Analysis of Financial Statements

Learning Objectives:
After studying this chapter, you should be able to:
1. Explain the basics of financial statement analysis.
2. Describe the standards of comparisons in financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Use ratio analysis to assess liquidity, profitability and solvency of a business.
BASICS OF FINANCIAL STATEMENT ANALYSIS
Analyzing financial statements involves evaluating three characteristics of an entity: its liquidity, its
profitability, and its solvency. For example, a short-term creditor, such as a bank, is primarily interested
in the ability of the borrower to pay obligations when they come due. The liquidity of the borrower in
such a case is extremely important in evaluating the safety of a loan. A long-term creditor, such as a
bondholder, however, looks to indicators such as profitability and solvency that indicate the firm’s ability
to survive over a long period. Long-term creditors consider such measures as the amount of debt in the
entity’s capital structure and the ability to meet interest payments. Similarly, shareholders are interested
in the profitability and solvency of the enterprise when they assess the likelihood of dividends and the
growth potential of the share.
Note: As you can see, different stakeholders are concern on the varied characteristics of an entity. It is
important for the companies to familiarized themselves with the need for information of those
stakeholders specifically on how to meet or exceed their expectations on such varied characteristics.
STANDARDS FOR COMPARATIVE ANALYSIS
Every item reported in a financial statement has significance. For example, when L. Victorina
Corporation reports cash of P 35,000,000 on its statement of financial position, it is known that the entity
had that amount of cash on the statement of financial position reporting date. However, it is not known
whether the amount represented an increase over the prior year or whether the amount is adequate in
relation to the entity’s need for cash. To obtain this information, it is necessary to compare the amount of
cash with other financial statement data. Comparisons can be made on a number of different bases:
1. Intracompany basis. This basis compares an item or financial relationship within an entity in the
current year with the same item or relationship in one or more prior years. For example a
comparison of L. Victorino’s cash balance at the end of the current year with last year’s balance
will show the amount of the increase or decrease. Likewise, L. Victorino can compare the
percentage of cash to current assets at the end of the current year with the percentage in one or
more prior years. Intracompany comparisons are useful in detecting changes in financial
relationships and significant trends.

2. Industry averages. This basis compares an item or financial relationship of an entity with
industry averages or norms published by financial ratings organizations. For example, L.
Victorino’s profit can be compared with the average profit of all entities in the same industry.
Comparisons with industry averages provide information as to an entity’s relative performance
within the industry.

3. Intercompany basis. This basis compares an item or financial relationship of one entity with the
same item or relationship in one or more competing entities. The comparisons are made on the
basis of the published financial statement of the individual entities. For example, L. Victorino’s
total sales for the year can be compared with the total sales of its major competitors.
Intercompany comparisons are useful in determining an entity’s competitive position.
TOOLS OF FINANCIAL STATEMENT ANALYSIS
Various tools are used to evaluate the significance of financial statement data. Three commonly used
tools are the following:
1. Horizontal analysis is a technique for evaluating a series of financial statement data over a
period of time.
2. Vertical analysis is a technique for evaluating financial statement data that expresses each item
in a financial statement in terms of a percent of a base amount.
3. Ratio analysis expresses the relationship among selected items of financial statement data.
HORIZONTAL ANALYSIS

 also called trend analysis, is a technique for evaluating a series of financial statement data over a
period of time.
 Its purpose is to determine the increase or decrease that has taken place, expressed as either an
amount or a percentage.
 Used to compare trends over time of any financial statement line items.
o For example, managers often want to tract changes on the statement of comprehensive
income in net sales and profit over time. If in a particular reporting period, net sales
increased by 8% and profit rose by 12% over the prior year, you can learn much
information from this. First, compare the performance of the line items with forecasts to
determine the level of entity performance. Some entities would consider an 8% increase
in net sales a dramatic failure while others would consider it a tremendous success; the
relationship of performance to forecast is the key. Further, the relationship between
distinct line items can give you a lot of insight into the health of the entity. In this
example, it is likely a very positive indication that profit rose at a much higher rate (12%)
than did net sales (8%). When you use horizontal analysis over time, you can spot
positive or negative trends.
For example, the recent net sales figures of L. Victorino Corporation are as follows:
L. Victorino Corporation
(Net Sales Stated in Millions)

2019 2018 2017 2016 2015

P 6,562.8 P 6,295.4 P 6,190.6 P 5,786.6 P 5,181.4

Assume that 2015 is the base year, percentage increases or decreases from this base period amount is
computed as follows:

Current year amount – Base year amount

Base year amount

For example, net sales for L. Victorino Corporation increased approximately 11.7% [(P5,786.6 – P
5,181.4) ÷ P 5,181.4] from 2015 to 2016. Similarly, net sales increased over 26.7% [(P 6,562.8 – P
5,181.4) ÷ P 5,181.4] from 2015 to 2019. The percentage of the base period for each of the 5 years,
assuming 2015 as the base period, is shown in the following illustration.

L. Victorino Corporation
(Net Sales Stated in Millions)
Base Period 2015

2019 2018 2017 2016 2015

P 6,562.8 P 6,295.4 P 6,190.6 P 5,786.6 P 5,181.4
127% 121% 119% 112% 100%

VERTICAL ANALYSIS
  a method of analyzing financial statements in which you can compare individual line items to a
baseline item such as net sales from the statement of comprehensive income, total assets from
the asset section of the statement of financial position, and total liabilities and owner’s equity in
the liabilities and owner’s equity section of the statement of financial position.
 The word vertical is used to describe this analysis method because the method generates a vertical
column of ratios next to the individual items on the financial statements.
 For example, on a statement of financial position, current assets are 22% of total assets with total
assets (the 100%) as the base amount. In the case of the statement of comprehensive income,
distribution costs or selling expenses are 16% of net sales with net sales (the 100%) being the
base amount.
 You can use vertical analysis to compare trends in the relative performance of any financial
statement line items over time.
o For example, from the statement of comprehensive income you may want to tract the cost
of goods sold and the profit as a percentage of sales. These two indicators let you know
whether year-to-year costs are becoming unreasonable and whether profit trends are as
desired. By tracking ratios over time, you can observe positive or negative trends so that
you can begin any required corrective actions. You can also use vertical analysis to
compare an entity’s performance relative to the performance of other entities operating in
similar industries.

Statement of Financial Position

The following illustration is the comparative statement of financial position of L. Victorino Corporation
for 2019 and 2018, analyzed vertically. The base, for the asset items is total assets, and the base for the
liability and equity items is total liabilities and equity.

L. Victorino Corporation
Condensed Statement of Financial Position
December 31

2019 2018
Amount Percent Amount Percent
Assets
Current Assets P 1,020,000 55.6% P 945,000 59.2%
Property and Equipment, Net 800,000 43.6% 632,500 39.7%
Intangible Assets 15,000 .8% 17,500 1.1%
Total Assets P 1,835,000 100.0% P 1,595,000 100.0%

Liabilities
Current Liabilities P 344,500 18.8% P 303,000 19.0%
Long-term Liabilities 487,500 26.5% 497,000 31.2%
Total Liabilities 832,000 45.3% 800,000 50.2%

Equity
Ordinary Share, P 1 par 275,400 15.0% 270,000 16.9%
value
Retained Earnings 727,600 39.7% 525,000 32.9%
Total Equity 1,003,000 54.7% 795,000 49.8%
Total Liabilities and P 1,835,000 100.0% P 1,595,000 100.0%
Equity

In addition to showing the relative size of each category on the statement of financial position, vertical
analysis may show the percentage change in the individual asset, liability and equity items. In this case,
even though current assets increased by P 75,000 from 2018 to 2019, they decreased from 59.2% to
55.6% of total assets. Property and Equipment – Net have increased from 39.7% to 43.6% of total assets,
and retained earnings have increased from 32.9% to 39.7% of liabilities and equity. These results may
signify that L. Victorino Corporation is choosing to finance its growth through retention of earnings
rather than through the incurrence of additional debt.

Statement of Comprehensive Income

Vertical analysis of the comparative statement of comprehensive incomes of L. Victorino Corporation
revealed that cost of goods sold as a percentage of net sales declined by 1% (62.1% vs 61.1%) and total
operating expenses declined by 0.4% (17.4% vs. 17.0%). Consequently, profit as a percent of net sales
increased from 12.3% to 13.4%.

L. Victorino Corporation
Condensed Statement of Comprehensive Income
For Years Ended December 31

2019 2018
Amount Percent Amount Percent
Sales P 2,195,000 104.7% P 1,960,000 106.7%
Sales Returns and Allowances 98,000 4.7% 123,000 6.7%
Net Sales 2,097,000 100.0% 1,837,000 100.0%
Cost of Goods Sold 1,281,000 61.1% 1,140,000 62.1%
Gross Profit 816,000 38.9% 697,000 37.9%
Distribution Costs 253,000 12.0% 211,500 11.5%
Administrative Expenses 104,000 5.0% 108,500 5.9%
Total Operating Expenses 357,000 17.0% 320,000 17.4%
Profit from Operations 459,000 21.9% 377,000 20.5%
Investment Revenues 9,000 0.4% 11,000 0.6%
Finance costs 36,000 1.7% 40,500 2.2%
Profit before Income Taxes 432,000 20.6% 347,500 18.9%
Income Tax Expense 151,200 7.2% 121,625 6.6%
Profit P 280,800 13.4% 225,875 12.3%

Common-Size Statements

The percentages in the statement of financial position and statement of comprehensive income of L.
Victorino Corporation can be presented as a separate statement that reports only percentages. Such a
statement is called a common-size statement.

On a common-size statement of comprehensive income, each item is expressed as a percentage of the net
sales amount. Net sales is the “common-size” to which we related the statement’s other amounts. In the
statement of financial position, the “common size” is the total on each side of the accounting equation –
total assets or the sum of the total liabilities and equity. Common-size statements can be used to compare
entities of different sizes.

RATIO ANALYSIS

Ratio analysis compares one indicator to another. Ratios can give you significant insight into the
performance and relative importance of two indicators. A ratio, which may either, be a percentage, a
rate, or simple proportion, expresses the mathematical relationship between one quantity and another.

Managers and investors can use ratio analysis to understand the health of an entity. Ratios lend insight
into many critical aspects such as present and future profit potential, expense control, and solvency. For
example, the ratio of profit to net sales gives substantially different information than examining profit and
net sales. Assume Corporation A has a profit of P 2,000,000 with net sales of P 25,000,000, and
Corporation B has a profit of P 1,800,000 on net sales of P 9,000,000. Corporation A and Corporation B
have profit-to-net-sales ratios of 8% and 20%, respectively. This indicates that although Corporation B
generated less profit than Corporation A, it operates with much higher profit margins. If Corporation B
operates in the same industry as Corporation A, corporation B is probably better managed.

For example, in 2018 G. Cadelina Corporation has current assets of P 41,338,000 and current liabilities of
P 29,226,000. In terms of percentage, current assets are 141% of current liabilities. In terms of rate,
current assets are 1.41 times greater than current liabilities. In terms of proportion, the relationship of
current assets to current liabilities is 1.41:1.

Financial statement ratios can be classified into three major groupings: liquidity, profitability and
solvency ratios.

LIQUIDITY RATIOS
Measuring the Ability to Pay Current Liabilities

Creditors and potential creditors are interested in continuously monitoring an entity’s ability to pay
interest as it comes due and to repay the principal of the debt at maturity. An analysis of a firm’s liquid
position provides indicators of its short-term debt-paying ability. Measures of liquid position are also used
to evaluate management’s current operating efficiency; thus, both investors and creditors are interested
in these statistics.

Working Capital

 This equation describes the amount of capital used to run day-to-day business operations.
 a measure of liquidity.
 necessary to finance an entity’s cash conversion cycle.
o The cash conversion cycle describes the process by which an entity converts cash into
products and then back into cash again.
 Working capital is current assets minus current liabilities; it is a measure of the liquid resources
that management will control in the short term.
 Low amounts of working capital can indicate the business is insufficiently liquid and could have
problems meeting current debt obligation.
 Very high working capital accounts could indicate ineffective management since current assets
seldom yield returns as great as long-term assets.
 A strong working capital position can be an advantage to an entity attempting to obtain short-term
credit at favorable interest rates. Investors and long-term creditors view a strong working
capital position as an indication that a firm will be able to make its expected dividend and interest
payments in a timely manner.
 Firms should seek to maintain working capital levels that provide sufficient current assets to meet
short-term debt requirements but in which current asset accounts are not so excessive that overall
entity profit margins suffer.
 When working capital is too low, increasing current assets and/or reducing current liabilities can
increase working capital.
 When working capital is trending too high, investing excess current assets in longer term assets,
which yield higher rates of return at acceptable risk levels, can decrease working capital levels.
W. Blanche Corp.’s working capital for 2018 follows:

Current Assets:
Cash P 5,368,000
Trading Investments 3,090,000
Accounts Receivable 35,382,000
Merchandise Inventory 62,582,000
Prepaid Expenses 2,870,000
Total Current Assets P 109,292,000
Less: Current Liabilities
Accounts Payable P 24,235,000
Accrued Payables 9,758,000
Income Tax payable 2,040,000
Current Portion of Long-Term Debt 3,000,000
Total Current Liabilities 39,033,000
Working Capital P 70,259,000

The formula and the calculation of W. Blanche Corp.’s working capital for 2018 follows:
Working Capital = Current Assets – Current Liabilities
Working Capital = P 109,292,000 – P 39,033,000
= P 70,259,000

Working capital for 2017 was P 53,189,000 (current assets of P 94,104,000 minus current liabilities of P
40,915,000). During 2018, working capital increased by P 17,070,000 (P 70,259,000 – P 53,189,000).
The increase indicates that more liquid resources were created than were used during the year. A decrease
in working would have indicated that the entity was using more liquid resources than it was creating. The
current ratio and the acid-test ratio are decision making tools based on working capital.
Current Ratio

 describes the ability of an entity to meet current debt obligations with assets that are readily
available.
 used to evaluate an entity’s liquidity and short-term debt paying capacity.
 obtained by dividing current assets by current liabilities.
 This statistics is often assigned great importance by lenders in making credit-granting decisions
since current assets and current liabilities represent the core of the core of the entity’s operations.
 The formula and the 2018 current ratio of W. Blanch Corp. follow:

Current Ratio = Current Assets

Current Liabilities

Current Ratio = P 109,292,000

P 39,033,000

= 2.80 or 2.8:1
This means that for every peso of current liabilities, W. Blanche Corp. Has P 2.80 of current assets. The
acceptable current ration depends on the nature of the industry.

 Higher ratios indicate an increased ability to pay short-term debt obligations such as accounts
payable and interest payments on debt.
 Lower ratios can indicate an inability to meet short-term debt obligations, which could lead to
insolvency and bankruptcy.
 A historic rule of thumb is that healthy current ratios equal or exceed the value of 2.0. However,
very high current ratios much in excess of 2.0, can indicate an entity is not using its assets in
ideal manner. This is because current assets seldom yield returns as large as long-term assets
such as investments in equipment and subsidiaries.

Too much reliance on the current ratio may not be advisable, as the following illustration demonstrates.
The current ratios for Corporation A and Corporation B are as follows:

Corporation A Corporation B
Current Assets:
Cash P 40,000 P 175,000
Accounts Receivable 60,000 125,000
Merchandise Inventory 180,000 95,000
Prepaid Expenses 20,000 5,000
Total Current Assets P 300,000 P 400,000
Current Liabilities P 100,000 P 200,000

Current Ratio P 300,000 = 3:1 P 400,000 = 2:1

P 100,000 P 200,000

Corporation A’s current ratio of 3:1 is much better than Corporation B’s 2:1. Upon inspection of the
composition of the current assets, however, A’s cash and accounts receivable are only one-third of total
current assets, while three-fourths of B’s current assets are composed of these two particular liquid
resources. So in reality, B may be in a better position to meet its current obligation than A is. Corporation
A can further improve its current ratio by paying off P 40,000 of current liabilities with the P 40,000 cash
on hand. If this is done, the new current ratio would be:

P 300,000 - P 40,000 P 260,000

Corporation A Current Ratio (revised) = = 4.33 : 1
P 100,000 - P 40,000 P 60,000

Such manipulation of current assets near the end of an accounting period can produce a ratio that may
satisfy creditors while actually weakening the immediate liquid position of the entity. Accountants
sometimes call this practice window dressing. It demonstrates that limiting an analysis to too few
statistics, relying on arbitrary rules of thumb, and not understanding the limitations behind the calculation
of a ratio are pitfalls that should be carefully avoided.
Quick Ratio

 Quick ratio or acid-test ratio tells whether the entity could pay all its current liabilities even if
none of the inventory is sold.
 those that may be converted directly into cash within a short period of time.
 These include cash, trading investments and receivables.
 Merchandise inventory is omitted because merchandise is normally sold on credit and then the
receivable must be collected before cash is realized. Thus, merchandise inventory is two steps
away from cash.
 Prepaid expenses are also omitted because they are usually relatively small in amount and
because they are used up in operations rather than converted into cash.

W. Blanche Corp.s quick ratio on Dec. 31, 2018 is calculated as follows:

Quick Assets
Quick Ratio =
Current Liabilities

Cash P 5,368,000
Trading Investments 3,090,000
Accounts Receivable (Net) 35,382,000
Total Quick Assets P 43,840,000

2018 Quick Ratio = P 43,840,000 = 1.12 or 1.12:1

P 39,033,000

Creditors generally use the rule of thumb that a quick ratio of at least 1:1 is satisfactory. W. Blanche
Corporation’s quick ratio appears to be acceptable.
The quick ratio, when considered with the current ratio, gives an idea of the influence of merchandise
inventory and prepaid expenses. Looking at the Corporation A and Corporation B illustration, by using
quick ratios, it is shown that corporation A’s current ratio may be misleading. Current ratio should not be
used as the sole indicator of short-term liquidity.
Corporation A Corporation B
Quick Assets:
Cash P 40,000 P 175,000
Accounts Receivable 60,000 125,000
Total Quick Assets P 100,000 P 300,000

Quick Ratio P 100,000 = 1:1 P 300,000 = 1.5:1

P 100,000 P 200,000

Corporation B has the stronger quick ratio though with a weaker current ratio, indicating that merchandise
inventory and prepaid expenses play a less important role in its current position than these assets do in
Corporation A’s.
Measuring the Ability to Sell Inventory and Collect Receivables
Accounts Receivable Turnover
Accounts receivable turnover measures the entity’s ability to collect from credit customers. It indicates
the number of times that the average balance of accounts receivable is collected during the period. The
ratio is calculated as follows:
Net Credit Sales
Accounts Receivable Turnover=
Average Net Accounts Receivable

In general, the higher the ratio, the more successfully the business collects cash. However, a turnover
that is too high may indicate that credit is too tight, causing the loss of sales to good customers.
Assuming that substantially all of W. Blanche’s sales are on credit, the 2018 receivables turnover is as
follows:
P 862,915,000
Accounts Receivable Turnover =
(P 32,936,000 + P 35,382,000)/2

= P 862,915,000
25.3 times
P 34,159,000

You can increase accounts receivable turnover by tightening credit policies and by more proactively
seeking payment of outstanding accounts. Note that tighter credit policies may have the undesirable effect
of reducing sales since some customers are likely to seek other suppliers with more liberal credit.
Average Age of Receivables
Average age of receivables provides a rough approximation of the average time that it takes to collect
receivables. Average age of receivables is determined as follows:
365 days
Average Age of Receivables =
Accounts Receivable Turnover

= 365 days
14.4 days
25.3 times

W. Blanche Corporation takes an average of 14 days to collect its receivables. If W. Blanche’s credit
terms are net 10 days, its collection efforts should be improved. If the credit terms are 15 or 30 days, W.
Blanche’s collection efforts appear to be excellent. The general rule is that the collection period should
not materially exceed the credit period.
Inventory Turnover
Inventory turnover is a measure of the number of times an entity sold its average level of inventory during
the period. A high rate of turnover indicates relative ease in selling inventory. However, a high value
can mean that the business is not keeping enough inventories on hand, and thus may result to lost sales.
Inventory turnover is calculated by dividing cost of goods sold by average merchandise inventory. Cost of
goods sold is used instead of net sales because both cost of goods sold and merchandise inventory are
stated at cost. The formula and the 2018 W. Blanche’s inventory turnover are as follows:
Inventory Turnover = Cost of Goods sold
Average Merchandise Inventory

P 564,346,000
Accounts Receivable Turnover =
(P 50,434,000 + P 62,582,000)/2

= P 564,346,000
9.99 times
P 56,508,000

Since W. Blanche’s inventory turned over about 10 times this period, the ending inventory should be
about 10% of cost of goods sold. W. Blanche’s ending inventory of P 62,582,000 is a little above this
amount (10% x P 564,346,000 = P 56,434,600). This excess is probably in anticipation of increasing sales
volume.
Higher inventory turnover ratios generally increase entity profitability since an entity can use the cash
normally tied up inventory for higher return investments. Higher inventory turnover is easier to
accommodate by improving a number of factors. These include production planning, scheduling, capacity
planning, product quality, equipment quality, relations with raw materials suppliers, and inventory
planning. Simply increasing inventory turnover without improvement in these critical areas can lead to
disastrous results.
Average Age of Inventory
Average age of inventory provides a rough measure of the length of time it takes to acquire, sell and
replace inventory. Average age of inventory is determined as follows:
365 days
Average Age of Inventory=
Inventory Turnover

Operating Cycle
This measures the average time period between buying the inventory and receiving cash proceeds from its
sales. It is determined by adding the average age of inventory and the average age of receivables.

PROFITABILITY RATIOS
Return on Total Assets
Return on total assets is a measure of management’s efficiency in using its assets to earn profits.
Creditors have loaned money to the entity and interest is their return. Shareholders have invested in
the entity and profit is their source of return. The sum of interest expense and profit is the returns to the
two groups who have financed the entity’s operations. The formula for computing this ratio follows:
Profit + Interest Expense
Return on Total Assets =
Average Total Assets

W. Blance Corporation’s return on total assets for 2018 is calculated as follows:

Return on Total Assets = Profit + Interest Expense
(Total Assets, Beg. Of Year + Total Assets, End of Year)/2

P 17,575,000 + P 3,120,000
=
(P 156,625,000 + P 172,583,000)/2

= P 20,695,000
.1257 or 12.57%
P 164,604,000

W. Blanche’s management earned an average of 12.57% on every peso asset invested.

Return on Ordinary Equity
Return on ordinary equity shows the relationship between profit and ordinary shareholders’ investment in
the entity. This rate may be higher or lower than the return on total assets, depending on how judiciously
management has combined debt and preference share with ordinary share in financing the entity’s
resources. The formula for computing this ratio is:
Profit + Preference Dividends
Return on Ordinary Equity=
Average Ordinary Equity
The numerator yields the profit available to the ordinary shareholders and is the net amount earned on the
equity of the ordinary shareholders. Average ordinary equity is an approximation of the amount invested
by this group of owners throughout the year.
Preference Dividends:
Par Value of Preference Share (at the time dividends are declared) P 500,000
Dividend Rate Paid 5%
Amount of Preference Dividends P 25,000

Average Ordinary Equity:

Total Equity - Preference Equity = Ordinary Equity

Jan. 1, 2018 P 87,710,000 - P 500,000 = P 87,210,000
+ Dec. 31, 2018 103,350,000 - P 500,000 = 103,050,000
 Total P 190,260,000
÷
Average ordinary equity for 2018 P 95,130,000

The return on W. Blanche Corporation’s ordinary equity for 2018 is:

P 17,575,000 – P 25,000
Return on Ordinary Equity = .1845 or 18.45%
P 95,130,000

Since the 18.45% return on ordinary equity exceeded the 12.57% return on total assets, management has
made effective use of leverage or trading on the equity. This difference resulted from borrowing at a
lower rate and investing the funds to earn a higher rate of return on ordinary equity. This practice is
directly related to the debt ratio; the higher the debt ratio, the higher the leverage. Trading on the equity
does not always guarantee improved profitability; it is because when revenues drop and operations
resulted to losses, interest on debts must still be paid.

Basic Earnings per Ordinary Share

Basic earnings per ordinary share is a measure of the profit earned on each ordinary shares. The formula
for a simple capital structure and the calculation of 2018 earnings per share for W. Blanche Corporation
follows:

BEPS = Profit – Preference Dividends

Average Number of Ordinary Shares Outstanding

P 17,575,000 + P 25,000
=
(9,500,000 shs. + P 10,000,000)/2

= P 17,550,000
P 1.80
9,750,000 shs.

Increasing profit can directly increase earnings per share. You can achieve this by providing highly
demanded products or services in a cost-effective manner. Highly demanded products or services can
increase net sales by causing sales of larger volumes of products or services at premium prices. By
producing the product or service in a cost-effective manner, you can increase profit margins to strengthen
earnings.

Corporations can also improve their earnings per share figures by repurchasing outstanding shares. This
will decrease the amount of shares outstanding and, for a fixed amount of earnings, inflate earnings on a
per-share basis. If an entity sells additional shares, dilution occurs and the opposite effect results; earnings
per share decline.

Price – Earnings Ratio

The price earnings (P/E) ratio indicates the degree to which investors value an entity. When investors pay
a high price for a given amount of corporate earnings, they increase the entity’s P/E ratio. The price-
earnings ratio is the ratio of the market price per ordinary share to the basic earnings per share. This
ratio reflects investor’s assessments of the entity’s future earnings. The formula for calculating the price-
earnings ratio is:
Market Price per Ordinary Share
Price – Earnings Ratio=
Basic Earnings Per Ordinary Share

The higher an entity’s P/E ratio, the more potential investors typically see in the particular entity.
Generally, corporations with higher P/E ratios tend to have higher growth rates and deliver products or
services that will probably be in demand for a significant time into the future. Because of such positive
projections, investors are willing to pay a higher share price in the hope that sales and earnings growth
will fuel further increases in share price.

Assuming a current market price of P 27 for W. Blanche Corporation’s ordinary share, the price-earnings
ratio for 2018 would be calculated as follows:
P 27
Price – Earnings Ratio = 15 or 15:1
P 1.80
W. Blanche’s share is currently selling at 15 times earnings. Investors are generally willing to buy a share
for as many as 15 to 20 times the current per-share earnings because they feel that the future profit growth
of the firm will be sufficient to provide an adequate return on this investment. This return is normally
received through a combination of dividends and an increased market value of the share. Many investors
interpret a sharp increase in a share’s price-earnings ratio as a signal to sell a share.

You can increase P/E ratios by increasing net sales and profit growth rates. Increasingly larger profit
margins also tend to increase P/E ratios. You can increase profit margins by controlling costs and by
maintaining optimum pricing by offering competitive, highly desirable products or services.

Dividend Yield

Dividend Yield is the ratio of dividends per share to the share’s market price. This ratio measures the
percentage of a share’s market value that is returned annually as dividends. This indication of the cash
payout rate on an investment allows shareholders and potential shareholders to compare interest rates on
certificates of deposit, corporate bonds, and other securities with this measure of return on ordinary share.

The formula for calculating 2018 dividend yield for W. Blanche Corporation assuming that P 8,000,000
cash dividends were paid to ordinary shareholders follows:

Cash Dividends per Ordinary Share

Dividend Yield =
Market Price Per Ordinary Share

Dividend Yield = P 8,000,000 ÷ 10,000,000 shs. P 0.80 = 0.0296 or 2.96%

P 27 P 27

This relatively low dividend yield rate of about 3% on W. Blanche Corp. ordinary share would not attract
investors who count on cash flow from dividends to pay their living expenses. A potential W. Blanche
Corp. shareholder would probably be more interested in speculating on the growth in the market value of
the share. This type of investor would rely more heavily on growth in earnings per share and recent trends
in the market price of the share than on the dividend yield.

SOLVENCY RATIOS

Solvency ratios measure the ability of the entity to survive over a long period of time. Long-term
creditors and shareholders are interested in the long-run solvency, particularly its ability to pay interest as
it comes due and to repay the principal of the debt at maturity.

Times Interest Earned Ratio

Times interest earned is a measure of how readily an entity can meet interest payments with profit earned
from operations. The times interest earned ratio indicates the margin of safety provided by current
earnings in meeting the entity’s interest responsibilities. The formula for calculating this ratio is:

Profit Before Interest Expense and Income Taxes

Times Interest Earned =
Annual Interest Expense

The ratio uses profit before interest expense and income taxes because this amount represents the amount
available to cover interest. Times interest earned for W. Blanche Corp. in 2018 is:

P 17,575,000 + P 3,120,000 + 9,463,462

Times Interest Earned =
P 3,120,000

= P 30,158,462 = 9.7 times

P 3,120,000

Thus, W. Blanche Corporation’s profit available to meet its interest responsibilities was way over 9 times
the amount of its interest expense. Usually, if interest is covered several times, long-term creditors
consider this an acceptable margin of safety.
Higher ratios indicate health entities that generate high income streams from operations and/or entities
that employ little or no debt. As the times interest earned ratios increase, there is typically less risk to
creditors that debt payment schedules will not be met.

Lower ratios indicate highly leveraged firms with significant interest expense and/or those firms that
generate small income streams from operations. While creditor risk increases as times interest earned
ratios decrease, there is the potential that the leverage gained with the financed debt may allow enhanced
future returns. Less mature entities, especially start-ups, will tend to exhibit lower ratios. This is because
these entities typically require larger amounts of debt because profit generation has not yet reached
optimum levels and because growth generally requires cash investments for assets such as inventories and
accounts receivable. You can achieve higher ratios by paying off debt and reducing interest expense
and/or increasing operations profitability.

Debt to Total Assets Ratio

Debt to total assets ratio or debt ratio shows the percentage of the entity’s assets financed by debt. Higher
ratios indicate that an entity has financed a large portion of assets with debt. As debt-to-asset ratios
climb, creditor risk increases because there is less margin available if the entity must liquidate assets.
Creditors may require higher interest rates or refuse to issue additional debt under these circumstances.
However, a certain degree of debt is generally quite acceptable; especially in the view of investors
because the leverage gained with debt financing may yield higher returns on equity investments.

You can determine an acceptable level of debt by examining the ratio of interest payments to operating
profit. In the case of start-ups or entities experiencing special situations, compare all sources of income
including additional debt financing with interest payments to ascertain the acceptability of current debt
levels. The higher this percentage is, the greater the risk that the entity will be unable to meet its
obligations when due. Thus, if the debt ratio is 100%, then debt has been used to finance all the assets.
The debt ratio for W. Blanche Corporation follows:

Total Liabilities
Debt to Total Assets Ratio =
Total Assets

Debt to Total Assets Ratio = P 69,033,000 0.399 or .40 or 40%

P 172,583,000

Thus, 40% of W. Blanche Corp.’ s total assets were financed by debt.

Equity to Total Assets Ratio

Equity to total assets ratio or equity ratio, shows the percentage of the firm’s assets financed by
shareholders. The higher this ratio is, the smaller the risk that the entity will be unable to meet its
obligations when due. Observe that debt ratio and equity ratio are complementary; that is, the two
percentages should always add up to 100%. This is true because all assets are financed by either debt or
equity funds. The equity to total assets ratio may be found by subtracting the debt to total assets ratio
from 100%.

Equity Ratio = 100% - Debt Ratio

Equity Ratio = 100% - 40% = 60%

This ratio may also be calculated by the following formula:

Equity Ratio = Total Equity

Total Assets

Equity Ratio = P 103,550,000 = 0.60 or 60%

P 172,583,000

Exercises
1. Which of the following ratios indicates high leverage for a corporation?
a. High working capital
b. High current ratio
c. High gross margin
d. High debt-to-equity ratio

2. Which of the following information cannot be determined from the statement of financial position
alone?
a. Current ratio
b. Debt-to-equity ratio
c. Return on equity
d. Retained earnings

3. Stocks with high P/E ratios that do not pay or pay low dividends would be typical of
a. Value stocks
b. Blue-chip stocks
c. Growth stocks
d. Utility corporation stocks

4. A corporation whose stock trades at P 40 per share and has earnings per share of P 5 decides on a
2-for-1 share split. After the share split, which of the following statements is true?
I. The earnings per share is P 5.
II. The earnings per share is P 2.50.
III. The price/ earnings ratio is 8.
IV. The price/ earnings ratio is 4.
a. I and III
b. II and IV
c. I and IV
d. II and III

5. Which of the following actions does not decrease working capital?

a. Paying off long-long term bonds three years before the maturity date.
b. Declaring a dividend.
c. Paying a dividend.
d. Buying machinery for cash.

6. Which of the following are changed when a corporation buys equipment for cash?
a. Total assets
b. Total liabilities
c. Current assets
d. Shareholders’ Equity

7. A corporation’s liquidity is best determined by which of the following indicators?

I. Quick Ratio
II. Book Value
III. Times interest earned
IV. Net working capital
a. I and II
b. I and IV
c. III and IV
d. II and III

8. Which of the following ratios cannot be calculated from a corporation’s statement of financial
position information only?
a. Leverage ratios
b. Current ratio
c. Coverage ratio (debt service ratio)
d. Book value

9. Which of the following is not a quick asset?

a. Cash
 b. Cash equivalents
c. Accounts receivable
d. Inventory

10. Which of the following ratios cannot be complied only from the statement of financial position
information?
a. Times interest earned ratio
b. Debt-to-equity ratio
c. Current ratio
d. Net working capital

11. Which of the following ratios would a creditor to a corporation be concerned about?
a. High quick ratio
b. Low P/E ratio
c. High debt-to-asset ratio
d. High accounts receivable turnover

12. If RDG Corporation earned P 1.50 per share last year and its stock traded at P 30 per share, what
should the corporation’s stock trade for if it earns P 2 per share this year?
a. P 35
b. P 40
c. P 50
d. P 60

13. A corporation earns P 5 per share and pays 10% in dividends. What is the dividend yield if the
stock is trading at P 25 per share?
a. 2%
b. 4%
c. 10%
d. 18%

14. Measures management’s efficiency in using its assets to earn profits

a. Return on ordinary equity
b. Basic earnings per share
c. Return on total assets
d. None of the above

15. Shows the percentage of the corporation’s assets financed by debt

a. Debt to total assets ratio
b. Equity to total assets ratio
c. Times interest earned ratio
d. None of the above

16. Provides a rough approximation of the average time that it takes to collect receivables
a. Inventory turnover
b. Average age of receivables
c. Accounts receivable turnover
d. None of the above

17. Measures how readily a corporation can meet interest payments with profit earned from
operations
a. Equity to total assets ratio
b. Times interest earned ratio
c. Debt to total assets ratio
d. None of the above

18. Shows the relationship between profit and ordinary shareholders’ investment in the corporation
a. Basic earnings per ordinary share
b. Return on ordinary equity
c. Return on total assets
d. None of the above
19. Compares one indicator to another and gives significant insight into the performance and relative
importance of two indicators.
a. Ratio analysis
b. Vertical analysis
c. Horizontal analysis
d. None of the above

20. Measures the corporation’s ability to collect from credit customers

a. Accounts receivable turnover
b. Average age of receivables
c. Inventory turnover
d. None of the above

Key Answers

1. D
2. C
3. C
4. D
5. C
6. C
7. B
8. C
9. D
10. A
11. C
12. B
13. A
14. C
15. A
16. B
17. B
18. B
19. A
20. A