Lesson 11 – Financial Ratio

Analysis
THINK ABOUT IT

How does one know if a business can pay its short-term debts or its
long-term debts? How does one know if a business is indeed profitable?
Write your answers below.
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Financial Ratio Analysis compares a company's current financial

position and performance with those of past years and identifies
strengths and weaknesses. It also allows a comparison of different
companies in different industries.

Financial Ratios in accounting can be classified into three groups:

• Liquidity Ratios
• Solvency Ratios
• Profitability Ratios

To illustrate the computation of the ratios, please refer to the Statement

of Financial Position and Statement of Comprehensive Income of Fidas
Merchandising.
 Fidas Merchandising
Statement of Financial Position
As of December 31
(in millions)

Assets 2019 2018 2017

Cash ₱222.9 ₱330.2 ₱290.0
Accounts Receivable (net) 282.5 172.1 156.0
Inventory 146.3 92.8 90.9
Prepaid Expenses 74.1 70.3 60.7
Total Current Assets ₱725.8 ₱665.4 ₱597.6
Property, Plant, and Equipment 1,866.4 556.2 625.5
Total Assets ₱2,592.2 ₱1,221.6 ₱1,223.1

Liabilities and Owner’s Equity

Accounts Payable ₱551.9 ₱620.6 ₱580.7
Non-Current Liabilities 1,822.4 376.6 400.0
Total Liabilities ₱2,374.3 ₱997.2 ₱980.7
Owner’s Equity 217.9 224.4 242.4
Total Liabilities and Owner’s Equity ₱2,592.2 ₱1,221.6 ₱1,223.1

Fidas Merchandising
Statement of Comprehensive Income
As of December 31
(in millions)

2019 2018 2017

Net Sales ₱2,213.3 ₱1,738.7 ₱1,543.2
Cost of Goods Sold 1032.1 831.8 700.1
Gross Profit ₱1,181.2 ₱906.9 ₱843.1
Selling and Administrative Expenses 889.2 659.2 555.5
Operating Income ₱292.0 ₱247.4 ₱287.6
Interest Expense 90.9 30.5 25.0
Income before Income Taxes ₱201.1 ₱216.9 ₱262.6
Income Tax Expense 60.3 65.0 77.4
Net Income ₱140.8 ₱151.9 ₱185.2
Liquidity Ratios measure the ability of the company to settle its
current obligations as they fall due. Here are the common types of
Liquidity Ratios:

1. Current Ratio – measures the ability of the business to pay its

short-term obligations as they fall due. Generally, a ratio of 1 or
1.5 is considered satisfactory to serve as the company's cushion
to its current liabilities although the industry average has to be
taken into consideration. To compute the current ratio the
formula is:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Example:

₱725.8
𝐶𝑅 2019 =
₱551.9

𝐶𝑅 2019 = 1.32

Interpretation: In 2019, Fidas Merchandising has ₱1.32

current assets to pay every ₱1.00 of current liabilities. This is
good because Fidas Merchandising has an excess of ₱0.32 after
paying its maturing current obligations.

2. Quick Ratio – measures the ability of the business to pay its

short-term obligations using its most liquid assets, i.e., cash,
short term investments, and trade receivables. It is also called an
acid test ratio. Quick ratio is a stricter measure of liquidity
because it only considers the current assets that can be
converted to cash easily or quickly. Quick ratio is computed
using the formula:

𝐶𝑎𝑠ℎ + 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Example:
TEACHER TIP:
Only Cash and Trade Receivable are used
₱222.9 + ₱282.5 to compute 2019's quick ratio because, in
𝑄𝑅 2019 =
₱551.9 2019, the company did not have any short-
term investments.

𝑄𝑅 2019 = 0.92

Interpretation: In 2019, the business has ₱0.91 of quick assets for

every ₱1.00 of current liability. Though the quick ratio is less
than 1, one must not jump into conclusions that the ratio is
unfavorable. Looking into the company's past year's quick ratio,
as well as its competitors’, may help in analyzing the ratio.

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3. Receivable Turnover – measures a company’s efficiency in
collecting the amount due from its customers. In general, a high
Receivable Turnover is favorable because it may indicate that
the company has strict collection policies and is aggressive in its
collection efforts. To compute receivable turnover, use this
formula:

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Where the formula for Average Trade Receivable is:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
=
2

Example:

₱2,213.3
𝑅𝑇 2019 =
(₱172.1 + ₱282.5) ÷ 2

𝑅𝑇 2019 = 9.74

Interpretation: In 2019, the business was able to collect its

accounts receivable 9.74 times.

4. Average Collection Period – this measures the number of days

it takes for a business to collect its obligations from customers’
account sales. The formula for Average Collection Period is as
follows:

360 𝑑𝑎𝑦𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Example:

360
𝐴𝐶𝑃 2019 =
9.74

𝐴𝐶𝑃 2019 = 36.96 𝑜𝑟 37 𝑑𝑎𝑦𝑠

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 Interpretation: In 2019, Fidas Merchandising took 37 days to
collect its receivable from its customers.

In interpreting the Average Collection Period, the favorability of

the ratio depends on the company's collection policies. In this
case, if the company's credit term is 30 days, 37 days is not
favorable as it exceeded the 30-day credit term. Therefore, it is
suggested that the business be stricter when it comes to its
collection of obligations. On the other hand, if Fidas’ credit term
is 45 days, 37 days is a favorable result.

5. Inventory Turnover – this measures the number of times a

company’s inventory is sold and replace in a year. Since a
company generates income through sales, a higher inventory
turnover means a higher income for the company. On the
contrary, a low inventory turnover suggests overstocking
inventory or the abundancy of obsolete items. A low inventory
turnover may also show poor purchasing methods of the
company i.e., items are bought in small quantity resulting in
insufficient stock that may result in losses. The formula for
computing inventory turnover is:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Where the formula for computing Average Inventory is:

𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2

Example:

₱1032.1
𝐼𝑇 2019 =
(₱92.8 + ₱146.3) ÷ 2

𝐼𝑇 2019 = 8.63

Interpretation: In 2019, Fidas Merchandising was able to sell and

replace its inventory 8.63 times.

6. Average Sales Period – this measures the number of days it takes

a business to sell and replace its inventory. Generally, a low
average sales period is favorable because it shows that a business
sells its inventory for a short period. The formula to compute the
Average Sales Period is:

360 𝑑𝑎𝑦𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

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 Example:

360
𝐴𝑆𝑃 2019 =
8.63

𝐴𝑆𝑃 2019 = 41.71 𝑜𝑟 42 𝑑𝑎𝑦𝑠

Interpretation: The Average Sales Period for Fidas

Merchandising is 42 days. This means it takes 42 days for Fidas
Merchandising to sell and replace its inventory.

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

company. The formula for working capital is:

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Example:

𝑊𝐶 2019 = ₱725.80 − ₱551.90

𝑊𝐶 2019 = ₱173.9

DRILL 11.1

Compute the 2018 and 2017 (if applicable) Liquidity Ratios of Fidas
Merchandising. Refer to its financial statement on page 12. Write your
answers to the space provided below. Ratios for 2019 are already
provided.

Ratio 2019 2018 2017

Current Ratio 1.32

Quick Ratio 0.92

Receivable Turnover 9.74

Average Collection
36.96
Period
Inventory Turnover 8.63

Average Sales Period 41.71

Working Capital ₱173.9

The answer to Drill 11.1 can be accessed

on your Teams.

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DRILL 11.2

Based on your answers on Drill 11.1, interpret the results by identifying

the most favorable and the least favorable year. Justify your answers.
Use the space below to write down your answers.

a. Current Ratio
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b. Quick Ratio
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c. Receivable Turnover
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d. Average Collection Period

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e. Inventory Turnover
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f. Average Sales Period

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 h. Working Capital
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Your answer to Drill 11.2 will be discussed
_____________________________________________________ during the synchronous discussion.

Solvency Ratios measure a business's capacity to pay its long-term

debts while maintaining operations indefinitely. It is also called
leverage ratios. Here are the common types of Solvency Ratios:

1. Debt Ratio – measures the extent of total assets financed by

liabilities. This is done by measuring the business’ liabilities as a
percentage of the total assets. Generally, a lower ratio is
favorable because it means that most of the company’s assets are
not financed thru credit. The formula for computing Debt Ratio
is:

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Example:

₱2,374.3
𝐷𝑅 2019 =
₱2592.2

𝐷𝑅 2019 = 0.92

Interpretation: In 2019, in every ₱1.00 of an asset, ₱0.92 is

financed by the creditors. This is not favorable because 92% of
the total assets were financed through credit.

2. Equity Ratio – measures the extent of assets financed by the

owner. This is done by measuring the owner's equity as a
percentage of total assets. Generally, a higher equity ratio is
favorable because it means that most of the entity's assets are
financed by the owners. The formula for computing Equity Ratio
is:

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Example:

₱217.9
𝐸𝑅 2019 =
₱2592.2

𝐸𝑅 2019 = 0.08
 Interpretation: In 2019, in every ₱1.00 of an asset, ₱0.08 is
financed by the owners. This is not favorable because only 8% of
the total assets were financed by the owners.
3. Debt to Equity Ratio – compares the financing provided by the
creditor against those provided by the owner. The optimal fair
ratio is 1. This means that the liabilities are equal to the owner’s
equity. The formula for debt to equity ratio is:
TEACHER TIP:
In Fundamentals of Accountancy, Business,
and Management 1, you learned that the
basic accounting equation is, A=L+OE.
This means that Assets may be financed
thru credit (Liabilities) or by the owners
(Owner’s Equity).
To illustrate, if you add the Debt Ratio and
Equity Ratio for 2019, the answer is 1.

0.92 + 0.08 = 1
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 This confirms the interpretation of Debt
and Equity Ratio and the equality of the
accounting equation. Generally, a 50:50
Example: ratio where liabilities and owner's equity
have the same proportion is the optimal
₱2374.3 debt ratio.
𝐷𝐸𝑅 2019 =
₱217.9

𝐷𝐸𝑅 2019 = 10.90

Interpretation: In 2019, for every ₱1.00 financed by the owner,

₱10.9 (1:10.9) was financed by the creditor. This is unfavorable
because the company will pay a large amount of interest in
paying the credit of the business.

4. Times Interest Earned – measures the business’ ability to pay

the interest coming from its liabilities. A high ratio is favorable
because it means that the company can pay its interest using its
Operating Income (or Income before Interest and Taxes). The
formula for Times Interest Earned is:

𝐼𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠

𝑇𝑖𝑚𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

Example:

₱292.0
𝑇𝐼𝐸 2019 =
₱90.9

𝑇𝐼𝐸 2019 = 3.21

Interpretation: In 2019, Fidas Merchandising can pay its interest using

its Operating Income 3.21 times.
DRILL 11.3

Compute the 2018 and 2017 (if applicable) Solvency Ratios of Fidas
Merchandising. Refer to its financial statement on page 12. Write your
answers to the space provided below. Ratios for 2019 are already
provided.

Ratio 2019 2018 2017

Debt Ratio 0.92

Equity Ratio 0.08

Debt to Equity Ratio 10.90

Times Interest Earned 3.21

DRILL 11.4

Based on your answers on Drill 11.3, interpret the results by identifying

the most favorable and the least favorable year. Justify your answers.
Use the space below to write down your answers.

a. Debt Ratio
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________

b. Equity Ratio
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________

c. Debt to Equity Ratio

_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________

d. Times Interest Earned

_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
The answer to Drill 11.3 can be accessed
on your Teams while your answer to Drill
11.4 will be discussed during the
synchronous discussion.
Profitability Ratios measure a company’s overall efficiency and
performance based on its ability to generate profit from operations in
relation to its assets and resources. There are four common types of
Profitability Ratios:

1. Gross Profit Ratio – a.k.a. Gross Profit Margin, this measures the
percentage of sales earned after deducting the cost of goods sold.
This serves as the mark-up that will be used to cover the
operating expenses and other expenses. A high Gross Profit
Ratio is favorable since there will be more operating income
after the operating expenses have been paid. The formula in
computing Gross Profit Ratio is:

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Example:

₱1,181.2
𝐺𝑃𝑅 2019 =
₱2,213.3

𝐺𝑃𝑅 2019 = 0.53

Interpretation: In 2019, for every ₱1.00 of sales earned, Fidas

Merchandising has ₱0.53 of gross profit that can be used to cover
the operating expenses of the business.

2. Operating Profit Ratio – measures the percentage of income

earned after the cost of goods sold and the operating expenses
have been deducted. In other words, the Operating Profit Ratio
is the income earned per peso after the cost of inventory and its
related operating expenses are deducted.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Example:

₱292.0
𝑂𝑃𝑅 2019 =
₱2,213.3

𝑂𝑃𝑅 2019 = 0.13

Interpretation: In 2019, for every ₱1.00 of sales earned, ₱0.13 is

the operating income after the cost of goods sold and operating
expenses have been deducted.
4. Net Profit Ratio – a.k.a. Return on Sales, this measures the
percentage of net income earned after all the expenses (COGS,
OpEx, and OE) have been deducted. The formula for computing
Net Profit Ratio is:

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Example:

₱140.8
𝑁𝑃𝑅 2019 =
₱2,213.3

𝑁𝑃𝑅 2019 = 0.06

Interpretation: In 2019, for every ₱1.00 of sales earned, Fidas

Merchandising had ₱0.06 of Net Income after all the expenses
have been deducted.

5. Return on Assets – a.k.a. Return on Investment, this measures

the company's efficiency in using its level of investment to
generate income. The formula for Return on Assets is:

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Where the formula for Average Total Assets is:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠
=
2

Example:

₱140.8
𝑅𝑂𝐴 2019 =
(₱2,592.2 + ₱1,221.6) ÷ 2

𝑅𝑂𝐴 2019 = 0.07

Interpretation: In every ₱1.00 invested in an asset, it gained ₱0.07

worth of net income.
DRILL 11.5

Compute the 2018 and 2017 (if applicable) Profitability Ratios of Fidas
Merchandising. Refer to its financial statement on page 12. Write your
answers to the space provided below. Ratios for 2019 are already
provided.

Ratio 2019 2018 2017

Gross Profit Ratio 0.53

Operating Profit Ratio 0.13

Net Profit Ratio 0.06

Return on Assets 0.07

DRILL 11.6

Based on your answers on Drill 11.5, interpret the results by identifying

the most favorable and the least favorable year. Justify your answers.
Use the space below to write down your answers.

a. Gross Profit Ratio

_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________

b. Operating Profit Ratio

_____________________________________________________
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_____________________________________________________
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_____________________________________________________

c. Net Profit Ratio

_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________

d. Return on Assets
_____________________________________________________
_____________________________________________________ The answer to Drill 11.5 can be accessed
on your Teams while your answer to Drill
_____________________________________________________
11.6 will be discussed during the
_____________________________________________________ synchronous discussion.
_____________________________________________________
INDEPENDENT WORK

Answer Worksheet 2 – Financial Ratios (Computation) in your

Teams.

ASSESSMENT

Answer Quiz No. 1 in your Teams.

MINI TASK

Answer Mini Task 2 in your Teams.

Go back to Lesson 11 objective/s in the Introduction part of this module.

Do you think you were able to achieve this lesson's objectives? If yes,
put a checkmark ü on the checkbox o and proceed with the next
module.