Financial Ratio Analysis

Chapter 4
Financial Ratio Analyses and Their Implications to Management
Learning Outcomes:
Upon finishing this session, the learner is expected to:
1. explain fully what a financial ratio is;
2. explain fully the objectives of financial ratio analyses;
3. explain fully and distinguish the limitations of financial ratio analyses; and
4. perform the steps in doing financial ratio analysis, interpretations, conclusions, and draw the
implications based on the results of the applied ratios.
Learning Contents
Chapter Prologue
In chapter 3, we have discussed the analysis of financial statements using horizontal,

vertical, and trend analysis. In this chapter, we shall continue analyzing and using financial
ratios as a tool.
Ratios present relationships between two variables. Financial ratios, therefore, refer to
the relationships between financial statement items or accounts expressed in mathematical
fashion.
In using these ratios, your task is to interpret them as favorable or unfavorable. To do

so, you should follow some standards that would determine the favorableness or
unfavorableness of the outcome. Some of the standard ratios used are based on:
1. Company budget for the same period;

2. Those used by the industry to which the firm belongs;
3. Those used by the firm’s successful competitors;
4. Those used by the firm using prior periods; and
5. Those used by the analyst in the past.
Industry ratios are averages developed by a group of experts involved in research. These
empirically-based ratios are used as standards in financial statement analysis. Industries have
their own peculiarities; hence, experts developed ratios that are suitable for that industry. Since
this task is too tedious, analyst resorts to using ratios of competitors, which are readily
available.
There should be consistency in the computation as well as usage of ratios to ensure

comparability between results and prevent their misinterpretation. Just like any financial
analysis technique, financial ratios are subject to limitations. Results from financial ratio
analysis are indicators of a firm’s weaknesses or strengths but are not in themselves, good or
bad. This is understandable since the ratios spring forth from financial statements, which are
subject to limitations.
Results derived from the computation of ratios could be presented as a percentage (%),
a fraction (1/4), a peso amount (P25.50), or a relative ratio (2:1).
ILLUSTRATIVE EXAMPLE
Let us use the figures of Riel Corporation in Chapter 3 as example. Assume further that
Riel Corporation is a leading department store of fashionable clothes and apparels with five
strategic branches located in the metro.
In this example, provided is the computation of the ratios for the current year. Compute
the ratio for the previous year.
Riel Corporation
Comparative Statement of Financial Position
December 31, 2025 and 2024
2025 2024
Assets
Current Assets
Cash & Cash Equivalent 106,789 102,375
Trade & Other Receivables 327,611 277,467
Inventory 334,863 297,654
Prepaid Expenses 101,565 114,813
Total Current Assets 870,828 792,309
Noncurrent Assets
Property, Plant, & Equipment
Intangibles 135,754 166,481
Total Noncurrent Assets 7,500 7,500
TOTAL ASSETS 143,254 173,981
1,014,082 966,290
Liabilities and Shareholder’s Equity
Current Liabilities
Trade & Other Payables
Unearned Revenues 238,000 208,703
Notes Payable – current 107,508 82,456
Total Current Liabilities 45,000 45,000
Noncurrent Liabilities 390,508 336,159
Notes Payable – noncurrent
Total Liabilities 208,422 253,500
Shareholders’ Equity 598,930 589,659
Preference Shares
P100 par
Ordinary Shares, P1 par
Premium on Ordinary Shares 105,000 105,000
Total Paid-in-Capital 15,000 15,000
135,000 135,000
Retained earnings 255,000 255,000
Total Shareholders’ Equity
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY 160,152 121,631
Total Shareholder’s Equity 415,152 376,631
TOTAL LIABILITIES & SHAREHOLDERS’S EQUITY 1,014,082 966,290

Riel Corporation
Comparative Income Statement
For the period ending December 31, 2025 and 2024
2025 2024
Sales P3,007,887 P2,732,712
Less: Cost of goods sold 2,208,520 1,964,865
Gross Profit 799,367 767,847
Less: Selling Expenses 372,000 345,000
Administrative Expenses 207,000 213,000
Total Operating Expenses 579,000 558,000
Operating Income 220,367 209,847
Less: Interest Expense 41,860 43,905
Net income before taxes 178,507 165,942
Less: Income Tax 62,477 58,080
Net Income after taxes P116,030 P107,862
In doing the analysis we shall cover the company status in terms of:
I. Liquidity/short-term solvency – pertains to the firms’ ability to pay any immediate and
incoming cash disbursements (payment of payables and operating costs and expenses).
II. Asset utilization liquidity analysis – measures how often the turnover of accounts
receivable, inventory, and long-term assets is. Stated differently, we measure the
liquidity of assets, namely: accounts receivable, inventory, and long-term assets. Along
with this, we also measure how efficient management use these assets.
III. Debt-utilization (leverage) ratios – estimates the overall debts status of the firm in light
of its asset base and earning power. We also measure the company’s ability to pay
interest and other fixed charges such as rent and payment of investment funds like
sinking funds, redemptions, pensions, etc.
IV. Profitability ratios – measures the firm’s capacity to earn sufficient return on sales, total
assets, and owners’ investment.
Solution:
Liquidity/Short-term Solvency
1. Current ratio
Current assets of P870,828
(2025) = = 2.23:1 or 223%
Current Liabilities of P390,508
Current ratio of 2.23:1 can be interpreted to mean that for every P1 of current
liability, the company has P2.23 current assets to pay it. This result may at times be considered
as favorable and satisfactory. It indicates that Riel is able to pay their current maturing debts,
with P1.23 to spare for every P1 of liability they have.
It is important to remember that no single current ratio is applicable or appropriate for

all businesses. Others may consider a ratio of 1:1 as satisfactory. A high current ratio does not
necessarily mean that the company is able to meet current maturing debts because the firm’s
current asset is composed mainly of inventories. Inventory is considered as a low-moving asset
in terms of its convertibility into cash.
Another asset that some analysis do not use in the computation of current ratio is
prepared expense. The reason is because they are not sources of cash. It represents the
consumption or use of future benefits like prepaid rent or prepaid advertisement. Consumption
of these does not entail cash inflow but recognition of expense for the company. So, a current
ratio with significant amount of prepaid expenses may not necessarily mean that the firm is
capable of paying current maturing obligations.
On the other hand, a company with a low current ratio may be able to pay current
maturing debts because the composition of its current asset is easily convertible to cash like
having collectible receivables and highly salable trading securities.
It is recommended to see whether the said ratio is favorable or not by comparing it with
the firm’s competitors or with the firm’s trend of liquidity over a period of 5 years.
2. Upward and Downward Movement of Current Ratio

Movements in current ratio components give rise to changes in the current ratio.
Ponder on the following statements and experiment using the figures of Riel
Corporation:
a. Increase in current assets or decrease in current liabilities increases the current

ratio.
Components Previous current Increase (decrease) New current ratio

ratio
Total current assets P50,000 P10,000 P60,000
Total current P25,000 P 25,000

liabilities
Current ratio: 2:1 2.4:1 increase

ratio
Total current assets P50,000 P50,000
Total current P25,000 P10,000 P15,000

liabilities
Current ratio: 2:1 3.3:1 increase
b. If the previous current ratio is 1:1 and there is an increase or decrease of the
same amount on both the total current assets and total current liabilities, it shall
have no effect on the new current ratio or the new current ratio will be the same
as the previous. To prove this, see the example below.
ratio
Total current P25,000 P10,000 P 60,000

liabilities
Current ratio: 1:1 1:1 no

effective/same ratio
c. If the previous current ratio is positive (current assets > current liabilities), and
there is an increase by the same amount in both total current assets and total
cur-rent liabilities, the ratio shall decrease and vice-versa. The opposite will
occur if the previous current ratio is negative (current liabilities > current assets).
ratio
Total current P25,000 P10,000 P 35,000

liabilities
Current ratio: 2:1 positive 1.71:1 decrease

ratio
Total current P50,000 P10,000 P60,000

liabilities
Current ratio: 0.5:1 negative 0.58:1 increase
3. Acid Test Ratio/Quick Ratio/ Liquidity Ratio
Quick Assets (Cash + Trading Securities + Receivables)

Of P106,789 + P327,611
(2025) = = 2.23:1 or 223%
Current Liabilities of P390,508
= 1.11:1 or 1.11% (2024)

(2024) =
The quick ratio is a stricter test of liquidity. This could be interpreted that for
every P1 liability, the firm has P1.11 of current assets to pay it. As you can see, Riel is not
as liquid as we pictured it to be when the current ratio was used. As a general rule, the
higher the quick ratio, the more liquid the firm is and thus, can pay its current maturing
debts.
Note that the inventories are ignored because of its nature being uncertain as
to their salability. Another reason for their exclusion from the formula is its uncertainty
as to when the item will be converted into cash. This is more so if the company is a
manufacturing entity where the inventory will be raw materials to work in process to
finished goods, converted to receivables, and eventually collected and converted into
cash.
Asset Utilization Liquidity Analysis

1. For Accounts Receivable
Accounts Receivable Turnover
Net Sales of P3,007,887
(2025) = = 9.94 times
Average Accounts Receivable of P277,467 + P327,611
(2025) =
Note: For the 2024 receivable turnover you may use the ending inventory of 2014 as the average
inventory.
Days’ Sales in Average Receivables or Average Collection Period

(2025) = = 9.94 times
Receivable turnover of 9.94 times
(2024) =
The ratio is used to measure the liquidity of the firm’s accounts receivable. The
result of 9.94 times could be interpreted to mean that the firm is able to collect all their
receivables 9.94 times in a year. A high turnover rate means that receivables are collected in a
short period of time. In Riel Corporation’s case, it is able to collect the average receivables
every 37 days or approximately every month. This has great bearing on management since a
high receivable turnover speeds up its conversion to cash and thus, management can use it
further to enhance company operations and ultimately, increase company profits.
High receivable turnover rate does not automatically mean good or efficient
collection of the company. The high turnover rate could be caused by any of the following:
a. Price level changes

b. Changes in sales terms
c. Special sales promotions
d. Strikes and plant shutdown during the previous period
e. Higher cash sales
f. [Turnover was] computed when most receivables are collected
2. For Inventory
Inventory Turnover Ratio
The inventory turnover rate pertains to the number of times the average inventory
is sold (finished goods and merchandise), used (raw materials), or processed (work-in-
process). The following formula are adapted depending on the nature of the inventory
being assessed:
Raw Materials Used

Raw Materials =
Inventory Turnover Average Raw Materials Inventory
Cost of Goods Manufactured

Work-in-Process =
Inventory Turnover Average Work in Process Inventory
Cost of Goods Manufactured
Finished Goods =
Inventory Turnover Average Finished Goods Inventory
Cost of Goods Sold

Merchandise =
Inventory Turnover Average Merchandise Inventory
Beginning Inventory + Ending Inventory

Average Turnover =
2
In our example, we used Merchandise inventory; hence, the turnover rate is

computed as:
Cost of Goods Sold P2,208,520

(2025) = = 6.98 times
P297,654 + P334,863
Average inventory of
2
(2024) =
Note: Use ending inventory of 2014 to compute 2014 inventory turnover.
The inventory turnover indicates the company’s efficiency in managing and

disposing inventory. As a general rule, the higher the turnover rate, the better. However, this is
not always the case because a high turnover rate may also indicate that the firm is
underinvesting in their inventory or suffering lost orders. It may also mean inventory shortages.
On the other hand, a low inventory turnover rate may indicate that the firm has too much
inventory in their warehouse or is harboring too much obsolete inventory. Low inventory
turnover may also mean that the company has slow-moving, or worse, inferior inventory stock.
Lastly, it may indicate slow and sales of the firm for the period. As an analyst, you must account
for the result of the turnover rates when reporting it to management.
Again, it is important to mention that financial ratios, including inventory turnover
rates vary, depending on the industry the firm belongs to. Firms that are involved in highly
perishable products like vegetables, fresh meat, and other agricultural products do have
relatively high inventory turnover. On the contrary, firms selling wines, jewelry, or automobile
have relatively low inventory turnover rates but higher profit yields.
For purpose of providing an interpretation for Riel Corporation, the result has a
relatively slight unfavorable inventory turnover. A dress store like Riel should be able to dispose
of their inventory quicker, since fashion is highly dynamic and the turnover of new clothes are
high; a higher turnover for Riel would be more appropriate. The management should
recommend and come up with strategies on improving the inventory turnover ratio.
Number of Days in Inventory or Average Sale Period
365
(2025) = = 52.30 days
Inventory Turnover of 6.98 times
(2024) =
The number of days in inventory indicates the number of days the entire inventory is
sold. As a general rule, the higher the result, the better. This indicates that since inventories are
sold out quickly, funds used for the inventories are quickly converted to cash, and ultimately
translated to more earnings. Riel’s days in inventory of 52.30 days can still be improved. It
would be better if management can dispose of their inventory in shorter number of days.
3. Property, Plant, and Equipment (PPE) or Fixed Asset Turnover

(2025) = = 3.04:1 or 304%
Average Total Assets of P1,014,082 +966,290
(2024) =
This ratio presents the company’s efficiency in utilizing their total assets to
generate revenue. Low turnover rate means that there is slow or low sales generation or that
there is too high investment in assets. Looking at Riel’s asset turnover rate (3.04:1), we can
interpret that for every P1 asset of the company, P3.04 of sales revenue is generated. Based on
this, we can infer that management utilized its assets efficiently. It can however, be
recommended that the company instills more asset utilization policies that would further
enhance asset usage efficiency.
Debt-Utilization (Leverage) Ratios
The leverage ratios allow the analyst to ascertain how efficient the company
manages its financial obligations. Under this, you need to compare the liabilities and owners’
equity vis-à-vis total assets or total liabilities and owners’ equity.
As previously mentioned in Chapter 3, the owners’ equity is considered as the
margin of safety by the creditors. This is because the owners’ equity is the amount that can
absorb any decline in asset. In other words, in case the assets of the company decline, the
owners’ equity is the amount that can be used to pay the creditors. In Riel corporation, the
total assets may decline by P415, 152 (amount of stockholders’ equity) or P598, 930 and the
company will still be able to pay its creditors.
The following ratios may be used in the analyses:
1. Debt to Equity Ratio
Total Liabilities of P598,930

(2025) = = 1.44:1 or 144%
Total Stockholders’ Equity of
P415,152
(2024) =
The use of borrowed funds in carrying out the firm’s operation is called trade on
equity. This means that the firm is willing to borrow money and pay fixed interest charges from
the loan. The borrowed money will be used to increase volume of operation and ultimately
earn more profit. This is an example of financial leverage.
When a firm borrows fund to be used in the business, the total assets (cash) and
total liabilities (bank loan) of the company increase; however, the owners’ equity remains the
same. If profits increase, the trading on equity (use of borrowed money would increase the
debt/equity ratio and rate of return on owner’s equity.
The debt/equity ratio presents the firm’s capital structure and its inherent risk. The
liabilities of the company present a risk, and blessings or benefit on the part of the owners. It is
a risk because if the company fails to use the borrowed money wisely to improve operations
the interest expense from their borrowings will be higher than their operating income
(operating loss). It will be a blessing, on the other hand, if the company is able to use the money
wisely to improve operations leading to higher income, and the higher income ultimately
increases owners’ equity. The high income exceeds the interest expense from the borrowings,
thus, making liabilities a blessing for the company. This structure indicates the trade-off
between risk and return.
The debt/equity ratio gauges the amount of risks involving the firm’s capital
structure in so far as the relationship of funds provided by the creditors (liabilities) and owners
are concerned. The higher the ratio, the riskier the capital structure.
Riel’s debt/equity ratio (144%) presents a high risk in the firm’s capital structure.
Management should be mindful of the efficient use of the company’s borrowing in improving
operations to ensure higher yields.
2. Debt Ratio
Total Liabilities of P598,930

(2025) = = 0.59:1 or 59%
Total Assets of P1,014,082
(2024) =
The ratio could be interpreted to mean that for every P1 asset of the company,
P0.59 was borrowed or was provided by the creditors. It basically presents the proportion of
borrowings to total assets. Generally, as explained earlier, the higher the debt proportion, the
higher is the risk. In addition to this, the risk is higher because if the firm gets bankrupt, the
creditors must be paid first. If the assets are not sufficient to pay all the debts, the owners will
end up with nothing.
Riel’s debt ratio (59%) presents a relatively high risk on the part of the company.
Management should be mindful of the risk from borrowings. In addition to this, the ratio may
bring about some difficulty on the part of management to borrow when they need it. Low
owner’s equity structure decreases the margin of safety for creditors.
3. Number of Times Interest Earned
Net Income before interest and Income tax or

Operating Income of P220,367
(2025) = = 5.26 times
Annual Interest Expense of P41,860
(2024) =
This ratio indicates the ability of the firm to pay fixed interest charges. It gauges
the company’s ability to protect long-term creditors. Riel’s times interest earned of 5.26 times
indicate that the firm is very much capable of paying its fixed interest charges from its operating
income.
Profitability Ratios
1. Gross Profit Ratio
Gross Profit of P799,367

(2025) = = P0.26 or 0.26:1 or
26%
(2024) =
This presents the gross margin per peso of sales. This is used to ascertain if the
gross margin or profit is sufficient to cover the operating expenses and the acquisition costs and
firm’s desired net income. It also gauges the firm’s ability to control production/acquisition
costs and inventories, including the mark-ups in the selling of their products. The said mark-ups
be more than adequate to cover not only the inventory related costs but also operating
expenses and achieve a desired profit for a period.
Riel’s gross profit ratio (P0.260 indicates their ability to earn more than adequate
sales revenue to cover their cost of selling the goods. However, a 26% gross profit ratio means a
74% cost ratio. This is relatively too high. Management must come up with more stringent cost
control measures to decrease cost of sales thereby increasing the gross margin ratio in the
succeeding years.
2. Net Profit Ratio or Profit Margin
Net Profit of P116,030

(2025) = = P0.039: P1 or 3.9 %
Net Sales of P3,007, 887
(2024) =
This ratio could mean that for every P1 sales revenue, the firm has P0.39 net
income. This gauges the profitability of the firm after including all revenues and deducting all
costs and expenses, and taxes. Riel’s net profit ratio of 39% is positive. However, management
should look closely to come up with measures that would increase revenue and decrease costs
in order to ensure and achieve profit maximization.
3. Return on Assets (ROA)
Net Income of P116,030
(2025) = = 0.12:1 or 12%
Average total assets of P1,014,082 + P966,290
2
(2024) =
(Du Pont Method) = Net Profit Ratio of 3.9% Total Asset Turnover of 3.04 = 12%
(2024) =
This could mean that every P1 asset used by the company to generate revenue, it
yielded P0.12 of net income. It gauges the profitability of the firm in the use of the total assets
or total liabilities and total owner’s equity.
4. Return on Equity
Net Income of P116,030
(2025) = = 0.12:1 or 12%
Ave. stockholders’ equity of P415,142 + P376,631
2
(2024) =
This could be interpreted to mean that for every P1 of invested capital by the owners
and used to generate revenue, it yielded P0.29 of net income. This ratio, just like the ROA, is
used to gauge the company’s efficiency in managing its total assets invested and in coming up
with return to shareholders.
5. Du Pont System of Analysis
After seeing and analyzing the ratios, you might think that they are too many. A man by
the name of Donald Brown, who happened to be Du Pont’s chief financial officer, thought of
the same thing. He came up with the Du Pont Equation of the Du Pont System Analysis. The Du
Pont company emphasized that satisfactory return on assets may be achieved by having high
profit margins / net profit ratio or by having a faster asset turnover, or a good combination of
both.
A favorable net profit ratio would indicate that the company has good control measures,
and a high asset turnover rate would mean efficient use of assets. Various industries have
various operating and financial structures. Companies belonging to industries with heavy/high
capital emphasizes high net profit ratio with a relatively low asset turnover. On the other hand,
the food processing industries emphasize low net profit margin and high turnover of assets
indicating a satisfactory return on assets.
The model includes the following formula to compute return on equity:
Return on Assets = Profit Margin or Net Profit Ratio x Asset Turnover
Debt Ratio = Total Liabilities/Total Assets
Equity Ratio = 1 – Debt ratio
Return on Equity Return on Assets
=
(Du Pont Method) Equity Ratio
Using the analysis for Riel Corporation:
Return on Asset = 12% (Du Pont)
Debt Ratio = 59%
12%
Return on Equity = = 29 %
1 – 59 %
RATIOS USED TO GAUGE COMPANY LIQUIDITY OR SHORT-TERM SOLVENCY
The following are the most common ratios to gauge a firm’s liquidity or short-term
solvency:
Ratio Formula Significance

Current Assets
1. Current ratio Current Liabilities
Signifies the firm’s capacity to
Note: Some analysts do not pay or meet current financial
include prepaid expenses in obligations
the computation of the
current assets
Current Assets
2. Quick ratio Current Liabilities A stricter test of liquidity;
suggests the firm’s ability to
Quick Assets Current pay current financial
Liabilities QA = cash + trading obligations by considering
securities + trade and other more liquid current assets
receivables
3. Current Assets to Total Current Assets Suggests the relative liquidity

assets or Working capital to Current Liabilities of the total assets and shows
Total assets the proportion of current
assets to total assets
4. Each current asset item to Each Current Assets item Signifies the proportion of
total current assets Total Current Assets each current asset item to
total assets; also indicates the
liquidity of the current assets
and the breakdown of each
component
5. Cash flow liquidity ratio Cash & cash equivalents + Gauges the firm’s ability to
Trading Securities + Cash flow pay current financial
from Operating obligations by considering
Activities cash and other cash
Current Liabilities equivalents
6. Defensive Interval ratio Current Liabilities Indicates the coverage of

Cash and Cash equivalents current liabilities
RATIOS USED TO GAUAGE ASSET MANAGEMENT EFFICIENCY AND LIQUIDITY
The following are the most common ratios to gauge a firm’s ability to efficiently
manage their assets and measure liquidity or short-term solvency:
1. Receivable Turnover Net Sales or Net Credit Sales Signifies the number of times
Average Receivables the average receivables are
collected during the year; also
measures’ the firm’s efficiency
in collecting their receivables
2. Average Collection 365 days of 360 days This ratio is very much related
Period or Number of Receivable turnover to accounts receivable
Days in Receivables turnover; indicates the
number of days the firm
collects its average
receivables. It implies the
efficiency of the firm in
collecting their receivables
3. Merchandise Turnover Cost of Goods sold Suggests the number of times

Average Merchandise the average inventory was
inventory disposed of during the
accounting period; also
signifies the over or under
investments of the firm in
inventory
4. Finished Goods Cost of Goods sold Suggests the number times

Turnover Average finished goods the average inventory was
inventory disposed of during the
signifies the over or under
investment of the firm in their
inventory
5. Work-in-Process Cost of Goods Manufactured Signifies the number of times

Turnover Average Work in Process average inventory was
inventory produced during the
indicates the time taken to
produce the products
6. Raw Materials Raw Materials Used Measures the number of
Turnover Average Raw Materials times average raw materials
Inventory inventory was used during the
period; also indicates the
sufficiency of the raw
materials available
7. Number of Days in 365 days or 360 days Indicates the number of days
Inventory Inventory Turnover by which inventories are used
or sold; implies the firm’s
efficiency in consuming or
selling inventories
8. Working Capital Cost of Goods Sold + Signifies the pace by which

Turnover Operating Expenses working capital is used also
(excluding charges not indicates the adequacy of
requiring working capital) working capital in the firm’s
OR operations
Net Sales
Average Working Capital
9. Current Asset Cost of Goods Sold + Signifies the pace by which

Turnover Operating Expenses + Income current assets are used; also
taxes + other expenses indicates the adequacy of
(excluding charges not current assets in the firm’s
requiring current assets like operations
depreciation and amortization
expenses)
Average Working Capital
10. Payable Turnover Net Credit Purchases or Net Signifies the firm’s ability to
Purchases pay trade payables; also
Average Trade and Other measures the number of
Payables or Accounts times the amount of average
Payables payables is paid during the
accounting period
11. Operating Cycle Day’s sales in merchandise Measures the length of time
(Trading Concern) inventory + No, of days to in order to convert cash to
collect receivables inventory to receivables and
back to cash
12. Operating Cycle No. of day’s usage in raw Measures the length of time
(Manufacturing materials inventory + No. of in order to convert cash to
Concern days in production process + raw materials inventory to
No. of day’s sales in finished work-in-process to finished
goods inventory + No. of days goods inventory to
to collect receivables receivables and back to cash
Average Cash Balance
13. Days Cash Cash Operating Costs Indicates the ability of the
365 days or 360 days firm’s cash to pay the average
daily cash obligations
14. Asset Turnover Net Sales Indicates the firm’s ability to

Average Total Assets efficiently manage their assets
to generate revenue
15. Property, Plant, & Net Sales Indicates the firm’s ability to
Equipment Turnover Average PPE Assets efficiently manage their PPEs
or Fixed Asset to generate revenue
Turnover
RATIOS USED TO GAUGE FIRM’S UTILIZATION OF DEBT AND COMPANY STABILITY
The following are the most common ratios used to gauge a firm’s stability or long-
term solvency.
1. Debt to Equity Ratio Total Liabilities Measures the relationship or

Owner’s Equity proportion of the capital
provided by creditors to the
capital provided by owners
2. Equity to Debt Ratio Owner’s Equity Measures the margin of safety

Total Liabilities of creditors
3. Proprietary of Equity Owners’ Equity Measures the proportion of

Total Assets firm’s assets coming from its
owners; signifies financial
stability of the firm and
cautions the creditors
4. Debt Ratio Total Liabilities Measures the proportion of
Total Assets the firm’s assets coming from
its creditors; also signifies the
extent or trading on equity
5. Fixed Assets to Total PPE or Fixed Assets (net) Measures the portion of the
Owners’ Equity Owners’ Equity owners’ equity used to
acquire fixed assets
6. Fixed Assets to Total PPE or Fixed Assets (net) Signifies whether the firm
Assets Total Assets over or under invested in PPE
7. Fixed Assets to Total PPE or Fixed Assets (net) Measures the extent covered
Long-Term Liabilities Total Long-Term Liabilities by the carrying value of PPE to
long-term obligations
8. Plant Turnover Net Sales Signifies the firm’s efficiency

Average PPE or Fixed assets in using their PPE
(net)
9. Book Value per Share Ordinary Shareholders’ Equity Measures the carrying value
Number of Ordinary Shares of net assets for every
Outstanding ordinary share outstanding;
also indicates the amount.
Which the shareholders can
recover if the firm sells its
assets upon liquidation or
converts them into cash at
their book values
10. Number of Times Net Income before Interest Signifies the firm’s capacity in
Interest Earned and Income Taxes paying fixed interest charges;
Annual Interest Charges measures the number of
times interest charges is
covered by the firm’s
operating income
11. Number of Times Net Income After Tax Measures the firm’s ability to
Preference Shares Preference Shares Dividend pay the preference
Dividend Requirement Requirement shareholders’ dividend
is Earned requirement
12. Number of Times Net Income before Taxes & Indicates the firm’s ability to
Fixed Charges are Fixed Charges pay annual fixed cahrges
Earned Fixed Expenses (Rent,
Interest, Sinking Fund
payments before taxes)
RATIOS USED TO GAUGE FIRM’S PROFITABILITY AND RETURN TO OWNERS
The following are the most common ratios used to gauge a firm’s profitability and
returns to owners.

1. Rate of Return on Net Income Measures the amount of net
Sales or Net Profit Net Sales income per pseo of sales; also
Ratio or Net Profit shows the proportion of net
margin income to the firm’s sales
revenue
2. Rate of Return to Total Return on Sales x Asset Measures the company’s

Assets (ROA) turnover profitability in using their total
OR assets; indicates the net
Net Income income generated by using
Average total Assets the firms’ total assets;
signifies management
efficiency in using their assets
to earn income
3. Asset Turnover Net Sales Signifies management

Average Total Assets efficiency in using their assets
to generate sales revenue
4. Gross Profit ratio Gross Profit Measures the gross profit per
Net Sales peso of sales revenue;
important in ascertaining the
adequacy of gross profit to
meet operating expenses plus
their desired profit
5. Operating Ratio Operating Income Measures the portion of sales

Net Sales revenue mused to cover
operating costs.
6. Cash flow margin Cash flow from Operating Indicates the firm’s ability to
activities translate sales unto cash
Net Sales
7. Rate of Return on Net Income Gauges management

Current Assets or Average Current Assets efficiency in using current
Working Capital assets to generate net income
8. Rate of Return on Net Net Income Measures management

working capital Average net working Capital efficiency in using net working
(Current assets – capital to generate revenue
current liabilities
9. Rate of Return on Net Income Indicates the amount of

Owner’s Equity Average Owners’ Equity return per peso of owner’s
equity; gauges management
efficiency in using its invested
capital to generate revenue
10. Earnings Per Share Net Income – Preference Measures the peso return on
share dividend requirement each ordinary share issued;
No. of Ordinary Shares signifies the firm’s ability to
Outstanding pay dividends
11. Price-earnings Ratio Market price per share Indicates the relationship
Average Current Assets between the market price or
ordinary shares and the
earnings of each ordinary
share
12. Earning-Price Ratio or Earnings Per Share Measures the rate at which
Capitalization Rate Market price per Share the share market is
capitalizing the value of
current earnings
13. Dividends Per Share Earnings Per Share Indicates the earnings
Ordinary Shares Outstanding distributed to the owners on
a per share basis
14. Payout Ratio or Dividends per Share Measures the percentage of

Dividends Payout Earnings Per Share the company’s earnings paid
to owners
15. Retained Earnings to Retained Earnings Measures the probability of

Share Capital Share Capital declaration of dividends by
the firm
16. Market Price to Book Market Price per Share Signifies the under or over-
Value per share Book Value per Share valuation of shares

Financial Ratio Analysis

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Financial Ratio Analysis

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Chapter 4

Financial Ratio Analyses and Their Implications to Management

Upon finishing this session, the learner is expected to:

1. explain fully what a financial ratio is;

2. explain fully the objectives of financial ratio analyses;

In chapter 3, we have discussed the analysis of financial statements using horizontal,

In using these ratios, your task is to interpret them as favorable or unfavorable. To do

1. Company budget for the same period;

There should be consistency in the computation as well as usage of ratios to ensure

Cash & Cash Equivalent 106,789 102,375

Trade & Other Receivables 327,611 277,467

Inventory 334,863 297,654

Prepaid Expenses 101,565 114,813

Total Current Assets 870,828 792,309

Property, Plant, & Equipment

Intangibles 135,754 166,481

Total Noncurrent Assets 7,500 7,500

TOTAL ASSETS 143,254 173,981

Liabilities and Shareholder’s Equity

Unearned Revenues 238,000 208,703

Notes Payable – current 107,508 82,456

Total Current Liabilities 45,000 45,000

Noncurrent Liabilities 390,508 336,159

Notes Payable – noncurrent

Total Liabilities 208,422 253,500

Shareholders’ Equity 598,930 589,659

Ordinary Shares, P1 par

Premium on Ordinary Shares 105,000 105,000

Total Paid-in-Capital 15,000 15,000

Retained earnings 255,000 255,000

Total Shareholders’ Equity

TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY 160,152 121,631

Total Shareholder’s Equity 415,152 376,631

TOTAL LIABILITIES & SHAREHOLDERS’S EQUITY 1,014,082 966,290

Sales P3,007,887 P2,732,712

Less: Cost of goods sold 2,208,520 1,964,865

Gross Profit 799,367 767,847

Less: Selling Expenses 372,000 345,000

Administrative Expenses 207,000 213,000

Total Operating Expenses 579,000 558,000

Operating Income 220,367 209,847

Less: Interest Expense 41,860 43,905

Net income before taxes 178,507 165,942

Less: Income Tax 62,477 58,080

Net Income after taxes P116,030 P107,862

It is important to remember that no single current ratio is applicable or appropriate for

2. Upward and Downward Movement of Current Ratio

a. Increase in current assets or decrease in current liabilities increases the current

Components Previous current Increase (decrease) New current ratio

Total current assets P50,000 P10,000 P60,000

Total current P25,000 P 25,000

Current ratio: 2:1 2.4:1 increase

Components Previous current Increase (decrease) New current ratio

Total current assets P50,000 P50,000

Total current P25,000 P10,000 P15,000

Current ratio: 2:1 3.3:1 increase

Total current assets P50,000 P10,000 P60,000

Total current P25,000 P10,000 P 60,000

Current ratio: 1:1 1:1 no

Total current assets P50,000 P10,000 P60,000

Total current P25,000 P10,000 P 35,000

Current ratio: 2:1 positive 1.71:1 decrease