Fundamentals of Accountancy,

Business and Management 2 First

Financial Ratios

ABM_FABM12- Ig-h-14 7
Ig-h-14
a

12
11
 Fundamentals of

Accountancy, Business

and Management II
Quarter I – Module 6:

Financial Ratios

This instructional material was collaboratively developed and reviewed

by educators from public and private schools, colleges, and or/universities. We
encourage teachers and other education stakeholders to email their feedback,
comments, and recommendations to the Department of Education at
action@deped.gov.ph.

We value your feedback and recommendations.

Fundamentals of Accountancy and Business Management 2 – Senior High School
Alternative Delivery Mode
Quarter 1 – Module 6: Financial Ratios
First Edition, 2020

Republic Act 8293, section 176 states that: No copyright shall subsist in any work of the
Government of the Philippines. However, prior approval of the government agency or office wherein the
work is created shall be necessary for the exploitation of such work for a profit. Such agency or office
may, among other things, impose as a condition the payment of royalties.

Borrowed materials (i.e., songs, stories, poems, pictures, photos, brand names, trademarks,
etc.) included in this book are owned by their respective copyright holders. Every effort has been exerted
to locate and seek permission to use these materials from their respective copyright owners. The
publisher and authors do not represent nor claim ownership over them.

Published by School & Division: San Jose City National High School, San Jose City Division
Schools Division Superintendent: JOHANNA N. GERVACIO, PhD CESE
Assistant Schools Division Superintendent: RONILO E. HILARIO
Curriculum Implementation Division Chief: VERONICA B. PARAGUISON, PhD
Supervisor In-Charge in Senior High School: LORDENNIS T. LEONARDO, PhD
Supervisor In-Charge: SIERMA R. CORPUZ
Principal: NENITA D. MARTIN

Development Team of the Module

Authors: DOMINGO F. MOLINA, MICAH ANGELICA A. MAPILI

Editor: Name

Reviewers: Name

Illustrator:

Layout Artist: Name

Management Team: Name

Printed in the Philippines by San Jose City National High School – Senior High School
Office Address: Cadhit St., Brgy. Calaocan, San Jose City, Nueva Ecijaa
Introductory Message
For the facilitator:

This module is provided to serve as reference of the teacher and can be used as
learning

material only. This can be a guide for parents and/or guardians in assisting the learners

in their learning process. Please instruct the learners to use separate answer sheets for

the evaluations, exercises and tests.

For the learner:

This module will help the learners understand Fundamentals of Accountancy Business

and Management 2 in a deeper focusing in the aspect of Financial Ratios. This will also

help the learner assess how the businesses run in different forms, taking into

consideration its advantages and disadvantages.

In this module, the learner can have a wider view of businesses focusing on businesses’

perception.

This module has the following parts and corresponding icons:

What I Need to Know This will give you an idea of the skills or

competencies you are expected to learn in the

module.

What I Know This part includes an activity that aims to

check what you already know about the

lesson to take. If you get all the answers

 correct (100%), you may decide to skip this

module.
What is It

This section provides a brief discussion of the

lesson. This aims to help you discover and

understand new concepts and skills.

WhThis comprises activities for independent

at’s More

practice to solidify your understanding and

skills of the topic. You may check the answers

to the exercises using the Answer Key at the

end of the module.

What I Have Learned This includes questions that you need to

answer so you can process what you have

learned from the lesson.

What I Can Do This section provides an activity which will

help you transfer your new knowledge or skill

into real life situations or concerns.

 This is a task which aims to evaluate your
Assessment
level of mastery in achieving the learning

competency.

In this portion, another activity will be given to

Additional Activities
you to enrich your knowledge or skill of the

lesson learned. This also tends retention of

learned concepts.

Answer Key This contains answers to all activities in the

module.

At the end of this module you will also find:

References This is a list of all sources used in developing

this module.

The following are some reminders in using this module:

1. Use the module with care. Do not put unnecessary mark/s on any part of the

module. Use a separate sheet of paper in answering the exercises.

2. Do not forget to answer What I Know before moving on to the other activities

included in the module.

3. Read the directions carefully before doing each task.

4. Observe honesty and integrity in doing the tasks and in checking your
 answers.

5. Finish the task at hand before proceeding to the next.

6. Return this module to your teacher/facilitator once you are through with it.

If you encounter any difficulty in answering the tasks in this module, do not hesitate

to consult your teacher or facilitator. Always bear in mind that you are not alone.

We hope that through this material, you will experience meaningful learning and

gain deep understanding of the relevant competencies. You can do it

 What I Need to Know

This module was created and designed to help you understand the Statement of
Cash

Flows in a more profound manner. It is here to help you determine the role of business
in the

environment, and how the environment affects the firm. The scope of this module
permits it to

be used in many different learning situations and strategies. It uses a language that will
fit the

diverse vocabularies of the learners. The lessons follow the DepEd’s Most Essential
Learning

Competencies (MELC) to keep on track with the Accountancy, Business and

Management

Programs of different schools.

This module is divided into three lessons as follows:

• Lesson 1 – Liquidity Ratios

• Lesson 2 – Solvency Ratios

• Lesson 3 – Profitability Ratios

After going through this module, you are expected to:

1. At the end of this lesson, the learners will submit a financial statement ratio
 analysis evaluation of sample company.

Introduction

Learning Objectives

A. Communicate learning objectives

At the end of the topic, I should be able to:

1. Solve exercises and problems that require computation and interpretation

using various financial ratios.

2. Using the downloaded sample financial statements, learner computes

various financial ratios and interprets the level of profitability, efficiency and

financial health (liquidity and solvency) of the business.

B. Present terms

At the end of this topic, I should be able to define and explain the following terms:

1. Liquidity Ratios

2. Solvency Ratios

3. Profitability Ratios

What I Know

1. Which of the following is not a current asset?

a. Inventory b. Prepaid Insurance c. Fixtures

2. Current asset MINUS current liabilities is the

a. Current Ratio b. Net Worth c. Working Capital

3. Current assets DIVIDED BY current liabilities is the

a. Current Ratio b. Net Worth Ratio Working Capital

4. The quick ratio EXCLUDES which of the following?

a. Accounts Receivable b. Inventory c. Cash

5. A corporation's excellent reputation will be listed among the corporation's assets

on its balance sheet.

a. True b. False

6. The current market value of a corporation is approximately the amount reported

on the balance sheet as stockholders' equity.

a. True b. False
7. Free cash flow is the cash provided by operating activities minus the cash used
by financing activities.

a. True b. False

8. The quality of a company's earnings are suspect when the company's net
income is more than the cash flow from which activities?

a. Operating b. Investing c. Financing

Direction: TRUE/FALSE

T 1. Ratio analysis involves a comparison of the relationships between financial statement

accounts so as to analyze the financial position and strength of a firm.

F 2. The current ratio and inventory turnover ratio measure the liquidity of a firm.
The
current ratio measures the relationship of a firm's current assets to its current
liabilities
and the inventory turnover ratio measures how rapidly a firm turns its inventory back
into a "quick" asset or cash.

F 3. If a firm has high current and quick ratios, this is always a good indication that a
firm is
managing its liquidity position well.

T 4. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that
can
be used to assess how effectively the firm is managing its assets in consideration of
current and projected operating levels.

F 5. A decline in the inventory turnover ratio suggests that the firm's liquidity
position is
improving.
Multiple choice QUESTIONS

D 6. Which of the following statements is most correct?

a. If a company increases its current liabilities by $1,000 and simultaneously

increases its inventories by $1,000, its current ratio must rise.

b. If a company increases its current liabilities by $1,000 and simultaneously

increases its inventories by $1,000, its quick ratio must fall.

c. A company’s quick ratio may never exceed its current ratio.

d. Answers b and c are correct.

E 7. Which of the following actions can a firm take to increase its current ratio?

a. Issue short-term debt and use the proceeds to buy back long-term debt with
a
maturity of more than one year.

b. Reduce the company’s days sales outstanding to the industry average and use the
resulting cash savings to purchase plant and equipment.

c. Use cash to purchase additional inventory.

d. Statements a and b are correct.

e. None of the statements above is correct.

E 8. Which of the following actions will cause an increase in the quick ratio in the short
run?

a. $1,000 worth of inventory is sold, and an account receivable is created.

The
receivable exceeds the inventory by the amount of profit on the sale,
which is
added to retained earnings.

b. A small subsidiary which was acquired for $100,000 two years ago and which was
generating profits at the rate of 10 percent is sold for $100,000 cash. (Average
company profits are 15 percent of assets.)

c. Marketable securities are sold at cost.

d. All of the answers above.

e. Answers a and b above.

C 9. Other things held constant, which of the following will not affect the current ratio, assuming
an initial current ratio greater than 1.0?

a. Fixed assets are sold for cash.

b. Long-term debt is issued to pay off current liabilities.

 c. Accounts receivable are collected.

d. Cash is used to pay off accounts payable.

e. A bank loan is obtained, and the proceeds are credited to the firm's
checking
account.

D 1o. Other things held constant, which of the following will not affect the quick ratio? (Assume
that current assets equal current liabilities.)

a. Fixed assets are sold for cash.

b. Cash is used to purchase inventories.

c. Cash is used to pay off accounts payable.

d. Accounts receivable are collected.

e. Long-term debt is issued to pay off a short-term bank loan

Analysis and
Lesson

Interpretation of

Proper Financial
Statements

What is It

FINANCIAL RATIOS

Financial ratios can be used to compare a company`s current financial position and
performance with those of past years and identify strengths and weaknesses. It also

allows comparison of different companies in different industries. Their use is not only

limited to management but to stockholders and creditors as well. Some creditors or

financial institutions require the presentation of certain ratios before they extend credit.

This is to ascertain the return of their money together with the interest.

In the process of using financial ratios to evaluate a company, ratios are often

divided into four categories as follows:

a. Liquidity – is the ability of the company to settle its current obligation as they

fall due.

b. Solvency – is the ability of the company to settle its non-current or long-term

obligations and the interest related to these obligations.

 c. Profitability – measures the company`s operating performance as a return on

tis investment. It gauges management`s efficiency in using company resources in

order to generate revenue.

d. Market Value or Valuation – measures the company`s potential for future

earnings, dividend payments and stock price growth

Lesson 1 - LIQUIDITY RATIOS

The liquidity ratio calculate the company`s current or quick assets against its

outstanding liabilities. Generally, a high ratio indicates that the company has low risk

of defaulting payment.

Common Types of Liquidity Ratios

1. Current Ratio = Current Assets

Current Liabilities

Current Ratio measures the ability of the business to pay its short-term

obligations as they fall due. Generally, a current ratio of 1 or 1.5 is considered

satisfactory to serve as a company`s cushion to its current liabilities although the

industry average has to be taken into consideration. However, some banks and

financial institutions require a current ratio of 2 or 3 before extending credit in order to

assure collection of the principal with interest. Nevertheless, this does not mean that

the higher the current ratio the better. Although a low current ratio may mean that the
company may not be able to pay its short-term debt as they mature, a very high current

ration may mean that the company is holding too much cash or liquid assets when in

fact, a part of these could be put in long-term investment which will yield higher income.

The component of the current assets should also be determined because a significant

part of it might be inventory and prepaid expenses.

Analysis

a. Current ratio for 2016 is 1.07 to 1 while that of 2017 is 1.32 to 1. This means that

for 2016, the company has ₱1.07 of current assets that can be converted to cash to
pay every peso of current liability while for 2017, the company has ₱1.32 of current

assets to cover every peso of current liability that will fall due.

b. Current ratio for 2017 increased signifying more liquidity for the company although

the company is satisfactorily liquid in 2016.

c. Analyzing the component of current assets for 2017, inventory and prepaid

expenses form only 30% of the current assets. Hence, the 70% is cash and receivable

which can readily be used to pay short-term liabilities.

2. Quick Ratio

Quick Ratio, otherwise known as the acid test ratio, measures immediate

liquidity with the ability to pay current liabilities with the most liquid assets. The quick

ratio is a more conservative measure of liquidity since it only considers current assets

that can be converted to cash easily or quickly. Current assets are composed of cash,

short-term investment, receivables, merchandise inventory and prepaid expenses.

From these, we can notice that merchandise inventory is not easily convertible to cash

as it has to be sold first which does not guarantee instant cash because sometimes, it

is sold on credit. Furthermore, some inventory items are slow moving. Due to

obsolescence, these items may not even be sold in the long run. On the other hand,

prepaid expenses will never be converted to cash since they are not considered when

computing for the quick ratio. To illustrate, the quick ratio of Fidas Merchandising is

computed as follows:

Quick Ratio = Cash + Short Term Investment + Trade Receivables

Current Liabilities
3. Receivable Turnover

Trade receivable turnover measures the efficiency to collect the amount due

from credit customers. Generally, a high trade receivable turnover is considered

favorable since it may indicate loose credit policies combined with inadequate

collection effort. However, imposing a very strict credit and collection policy may lead

to lesser sales as some customers may opt to buy from other companies with more

lenient credit terms.

Receivable Turnover = Net Credit Sales

Average Trade Receivable

Average Trade Receivable =Beginning Trade Receivable + Ending Trade Receivable

4. Average Collection Period

Average collection period, otherwise called day`s sales outstanding, is the

approximate number of days it takes a business to collect its receivables from credit

or account sales. In assessing whether the average collection period is favorable or

unfavorable, the credit terms extended by the company to its customers should
be

considered. Average collection period has two formulas as follows:

Average Collection Period = 360 Days

Trade Receivable Turnover

5. Inventory Turnover

Inventory turnover measures the number of times a company`s inventory is sold

and replaced during the year: Since the company generates income from sales, the

faster the movement of inventory, the higher the company`s net income. Low inventory

turnover my indicate overstocking of inventory or the presence of obsolete items. This

is not favorable as inventory items tend to deteriorate, spoil or be obsolete

when

stocked in the warehouse for some time unless it is planned stocking in anticipation of

product shortage or price increases. High inventory turnover may indicate strong

sales. However, it may also indicate inefficient purchasing where purchases are made

often in small quantities resulting to insufficient stock of goods or inadequate inventory

levels. This may result to losses in terms of sales as customer demand is not served
when the product is out of stock. This may also result to higher purchase price of goods

as the company cannot avail of the maximum trade discount available due to

purchases made in small volumes.

Inventory Turnover = Cost of Goods Sold

Average Inventory

Average Inventory = Beginning Inventory + Ending Inventory

6. Average Sales Period

Average sales period, otherwise known as the inventory conversion period, is

the average time to convert inventory to sales. Generally, the lower the average sales

period, the more favorable it is for the company since it signifies a shorter period to

sell inventory.

Average Sales Period = 360 days

Inventory Turnover

7. Working Capital

Working capital measures the short term liquidity of a company.

Working Capital = Current Assets – Current Liabilities

Lesson II – SOLVENCY RATIOS

Common Types of Solvency Ratios

1. Debt Ratio

Debt ratio, otherwise known as the debt to assets ratio, measures business

liabilities as a percentage of total assets. It measures the extent of total assets

financed by liabilities. Generally, a lower ratio is favorable since it means that more

funds are provided by the owner. In discussing a company`s source of funds, we go

back to the fundamental accounting equation Assets= Liabilities +Owner`s Equity. The

accounting equation very well shows that business funds come from two
sources,

namely, liabilities from creditors and owner`s equity from the owner. Generally, 50-50
ratio where liabilities and owner`s equity have the same proportion is considered fair

as this is determined to be the optimal debt ratio. However, a slightly higher debt ratio

is also acceptable although we have to take into account the industry and the payment

history of the company.

Debt Ratio = Total Liabilities

Total Assets
Example

2017 2016 2015

Debt Ratio ₱2,374.3 = 91.6 ₱ 997.2 = 81.6 ₱ 980.7 = 80.2

₱2,592.2 ₱1,221.6 ₱1,223.1

Since 2015, Fidas Merchandising was heavily financed by creditors. In 2015, 80.2%

of the assets was already financed by creditors. This went slightly higher in 2016 as

debt ratio was 81.6%. In 2017, debt ratio was even higher at 91.6%. This is not a good

sign as the company heavily sourced its financing from creditors. The company
is

considered highly leveraged and this is risky for the company because most of
its

assets are owned by the creditors. In simple words, the company will have to sell most

of its assets to pay its creditors.

2. Equity Ratio

Equity ratio measures the percentage of the total assets financed by the

owner`s investment. It measure the extent of total assets owned by the owner. This is

his/her stake in the company. Generally, the higher the equity ratio, the more favorable

it is for the company. This is also an advantage if the company is to apply for a loan

as potential creditors will find the company less risky.

Equity Ratio = Total Equity

 Total Assets

Example

2017 2016 2015

Equity Ratio ₱217.9 =8.4 ₱224.4 = 18.4 ₱242.4 = 19.8

₱2,592.2 ₱1,221.6 ₱1,223.1

Fidas Merchandising`s equity ratio is 19.8% for 2015. This slightly went down

to 18.4% in 2016 then went down further to 8.4% in 2017. These rates are critically

low for the company as these indicate dependence on creditors for sources of funds.

For 2017, the owner only owns 8.4% of company assets while the creditors own
91.6%. For 2016 and 2015, the owner owns 18.4% and 19.8% respectively while the

creditors own 81.6% and 80.2% respectively. This is way below the optimal fair ratio.

3. Debt to Equity Ratio

Debt to equity ratio, otherwise knowns as financial leverage ratio, measures the

financing provided by the creditors against those provided by the owner. This

measures the extent of the borrowed funds as compared to the investment by

the

owner. The optimal fair ratio is 1 or 100%. This means that liabilities are equal
to

owner`s equity. The higher the ratio, the higher the risk as interest payments on

liabilities are onerous. Hence, a lower ratio is favorable.

Debt to Equity Ratio = Total Liabilities

Total Equity

2017 2016 2015

Debt to Equity Ratio ₱ 2,374.3 =10.9 ₱ 997.2 = 4.4 ₱980.7 = 4.0

₱217.9 ₱224.4 ₱242.4

The debt to equity ratio is increasing through the years. In 2015, debt equity

ratio was 4:1 which meant that for every ₱1 financed by the owner in the assets of the

business, ₱4 was financed by the creditors. The following year showed a slightly

higher ratio that for every ₱1 financed by the owner, ₱4.40 was financed by the
creditors. During 2017, the creditors heavily funded the assets of the company that for

every ₱1 funded by the owner, the creditor funded ₱10.90. This is very unfavorable

since the company will definitely pay huge interest for the use of creditor funds in the

business. This is evident as the interest expense surged in 2017 which can be seen

in the income statement.

4. Times Interest Earned

Times interest earned measures the company`s ability to pay the interest

charged to the company for its outstanding liabilities. It measures the number of times

operating income can cover interest expense, the more favorable it is for the creditors

because it means the company is not struggling to pay its interest from loans.
Times Interest Earned = Income before Interest and Taxes

Interest Expense

Example

2017 2016 2015

Times Interest Earned ₱292.0 = 3.2 ₱247.4 = 8.1 ₱287.6 = 11.5

₱ 90.9 ₱30.5 ₱25.0

Fidas Merchandising`s interest is 11.5 times of its income before interest and

taxes in 2015, 8.1 times in 2016, and 3,.2 times in 2017. The decrease in number of

times may be due to increasing interest payments from large amounts of loans.

Lesson II - PROFITABILITY RATIOS

Profitability ratios measure a company`s overall efficiency and performance based on

its ability to generate profit from operations relative to its available assets and

resources.

Common Types of Profitability Ratios

1. Gross Profit Ratio

Gross Profit Ratio, otherwise called Gross Margin Ratio, measures the

percentage of peso sales earned after deducting cost of goods sold. Hence, this is the

percentage of mark-up a company adds to the cost of its inventory which will
later
absorb the operating expenses related to the sale of the goods. A high gross profit is

favorable as there will be greater operating income after all operating expenses have

been paid.

Gross Profit Ratio = Gross Profit

Net Sales

Fidas Merchandising`s gross profit was 54.6% is 2015. This was slightly lower

in 2016 at 52.2%. However, it went slightly higher in 2017 at 53.4%. The gross profit

margin for three years was not bad as the mark-up was more than 50% which will be

used to absorb the operating expenses.

Example
 2017 2016 2015

Gross Profit Ratio ₱1,181.3 = 53.4% ₱906.9 = 52.2% ₱843.1 = 54.6%

₱2,213.3 ₱1,738.7 ₱1,543.2

2. Operating Profit Margin

Operating profit margin measures the percentage of income earned after

deducting the cost of sales and the operating expenses. In short, it is the
income

earned per peso of net sales after the cost of inventory and the related
operating

expenses are deducted. This is an indication of how the company is effectively and

efficiently managing its expenses at its sales level. Hence, a higher ratio is favorable

since it indicates efficiency in managing expenses.

Operating Profit Margin = Operating Income

Net Sales

Example

2017 2016 2015

Operating Profit Margin ₱292.0 = 13.2% ₱247.4 = 14.2% ₱287.6 = 18.6%

₱2,213.2 ₱1,738.7 ₱1543.2

Operating Margin has a downward trend. From 18.6% in 2015, it went down to

14.2% in 2016 then to 13.2% in 2017. This indicates that the company is not efficiently

managing its expenses. A closer look at the company`s income statement reveals that
selling and administrative expenses show an increasing trend. If his upward trend in

operating expenses will continue, it follows that operating margin will continue its

downward trend. If this will be the case, the company will end up incurring losses.

3. Net Profit Margin

Net Profit Margin, otherwise knowns as Return on Sales, measures the

percentage of net income earned from net sales after all other income has been added

and all operating expenses and other expenses including income taxes have
been

paid. A high net profit margin is favorable to the company.

Net Profit Margin = Net Income
Net Sales

Example

2017 2016 2015

Operating Profit Margin ₱140.8 = 6.4% ₱151.9 = 8.7% ₱185.2 = 12%

₱2,213.3 ₱1,738.7 ₱1,543.2

The net profit margin continued to decrease every year from 2015 to 2017.

From 12% in 2015, it went down to 8.7% in 2016 then to 6.4% in 2017. Management

should exert effort to increase sales and cut on expenses if they want to improve net

income for future operations

4. Return on Assets

Return on Assets, otherwise called Return on Investment, measures the

company`s efficiency in using its level of investment in assets in order to

generate

income. Generally, a high ratio is favorable. Since capital assets are one of the

company`s investments, the return on assets measures the income derived from these

asset acquisitions.

Return on Assets = Net Income

Average Total Sales
Average Total Assets = Assets at Beginning of the Year + Assets at Ending of the Year

Example

2017 2016

Return on Assets = ₱140.8 = 7.4% ₱140.8 = 12.4%

(₱2,592.2 + ₱1,221.6)/2 (₱1,221.6 + ₱1,223.1)/2
The return on assets was 12.4% in 2016. This decreased to 7.4% in 2017

despite heavy acquisitions of property plants and equipment in 2017. This means that

company assets were not fully utilized to generate income.

Qualitative Factors in Financial Statement Analysis

After discussing the quantitative factors which consist of mathematical formulas

and numbers, it must be noted that there are other factors that are equally important

in analyzing financial statements. In the process of analysis, not only are the

quantitative factors significant. The qualitative factors are likewise significant as

follows:

1. Customers

Some companies have multitude of customers as source of income which is

healthy as the loss of one or two customers will not have an impact on company sales.

However, there are some companies who have only few customers whose sales rely

heavily on one, two or three customers. This is very dangerous as the loss of one of

these major customers can have a big impact on company sales.

2. Competitors
The company`s competitors may dictate the price of the product in the industry.

Thus, in pricing its products, not only are the cost of producing the product considered

but the prices of the competitors` product

3. Market Share

The market share can determine the leaders in the industry. Most of the time,

the industry leaders have the advantage over small companies as they dictate
the

trend and the price while small companies tend to just follow.

4. Industry Growth

This is one important factor to consider because a growing industry means

more customers. Trend and new innovations in the industry will also have to be
considered. A company manufacturing beta max and VHS tapes noticed a decline in

sales when compact discs were introduced. On the other hand, the manufacturers of

the compact disc experienced the same decline in sales due to the introduction of the

DVD. In like manner, the same was experienced by the manufacturer of the
DVD

because of the introduction of the blu ray disc. This cycle will continue because the

industry is continuously growing and evolving.

5. Supplier

The presence of many suppliers will cause the prices to drop as there are many

competitors. However, the presence of few suppliers may cause these suppliers
to

dictate the prices especially during times of shortage of supplies.

What I Have Learned

1. What is liquidity ratio?

2. Give the formula of each of the following liquidity ratios:

• Current Ratio

• Quick Ratio

• Receivable Turnover

• Average Collection Period

• Inventory Turnover

• Average Sales Period

• Working Capital
3. What is a solvency ratio?
4. Give the formula of the following solvency ratios:

• Debt Ratio

• Equity Ratio

• Debt to Equity Ratio

• Times Interest Earned

5. What is a profitability ratio?

6. Give the formula of the following profitability ratio:

• Gross Profit Ratio

• Operating Profit Margin

 • Net Profit Margin

• Return on Assets

What I Can Do

Direction: Choose the correct answer

1. Identify the type of ration given in each number. Write the letter of the correct

answer on the blank provided.

a. Liquidity Ratio b. Solvency Ration c. Profitability Ratio

1. Debts to Equity Ratio 10. Operating Profit Margin

2. Inventory Turnover 11. Equity Ratio

3. Average Sales Period 12. Quick Ratio

4. Return on Assets 13. Debt Ratio

5. Working Capital 14. Net Profit Margin

6. Times Interest Earned 15. Receivable Turnover

7. Gross Profit Ratio

8. Current Ratio

9. Average Collection Period

2. Listed below are ratios for 2016 and 2017. Identify whether the change in

the ratio value is favorable or unfavorable by stating the general rules.

 2017 2016

1. Current Ratio 1.5 1.3

2. Quick Ratio 0.86 1.1

3. Receivable Turnover 12 11
4. Average Collection

Period 32 28

5. Inventory Turnover 10 8
6. Average Sales

Period 38 45

7. Debt Ratio 45% 48%

8. Equity Ratio 55% 60%

9. Debts to Equity

Ratio 3 4
10. Times Interest

Earned 6 8

11. Gross Profit Ratio 35% 42%

12. Operating Profit

Margin 25% 20%

13. Net Profit Margin 12% 15%

14. Return on Assets 21.80% 19.60%

Assessment
I - Direction. Answer the test carefully. Write the answers on a separate sheet of
paper.

Rainbow Trading

Statement of Financial Position

As of December 31

Assets 2017 2016

Current Assets

,000 ₱64,000
Cash ₱58

Trade Receivables 228000 170000

Merchandise Inventory 226000 222000

Prepaid Expenses 12000 16000

Total Current
4,000 ₱472,000
Assets ₱52
Property, Plants, and Equipment (net) 1050000 816000
 ₱1,288,00
Total Assets ₱1,574,000 0

Liabilities and Owner`s Equity

Current Liabilities

4,000 ₱252,000
Trade Payable ₱28
Non-Current Liabilities

Loan Payable 578000 396000

Total Liabilities ₱862,000 ₱648,000

Owner`s Equity 712000 640000

₱1,288,00
Total Liabilities and Owner`s Equity ₱1,574,000 0

Raibow Trading

Income Statement

For Years Ended December 31

(in millions)

2017 2016
Net Sales ₱1,716,000 ₱1,606,000

Cost of Goods Sold 1,026,000 1,018,000

Gross Profit ₱690,000 ₱588,000

Selling and Administrative

Expenses 488,000 474,000

Operating Income ₱202,000 ₱114,000

Interest Expense 40,000 28,000

Income before income taxes ₱162,000 ₱86,000

Income Tax Expense 66,000 34,000

Net Income ₱96,000 ₱52,000

Required: Compute the following ratios for 2017:

1. Current Ratio 5. Inventory Turnover

2. Quick Ratio 6. Average Sales Period

3. Receivable Turnover 7. Working Capital

4. Average Collection Period 8. Debt Ratio

9. Equity Ratio 13. Operating Profit Margin

10. Debt to Equity Reatio 14. Net Profit Msrgin

11. Times Interest Earned 15. Return on Assets

12. Gross Profit Ratio

Additional Activities

1. Multiple choice

Merdana Trading Ltd. financial statements.

1. Which statement best describes Merdana Trading Ltd.’s acid-test ratio?
a. Greater than 1
b. Equal to 1
c. Less than 1
d. None of the above

2. Merdana Trading Ltd.’s inventory turnover during 2019 was?

 a. 6 times.
b. 7 times
c. 8 times.
d. Not determinable from the data given.

3. During 2014, Merdana Trading Ltd.’s days’ sales in receivables ratio was?
a. 34 days
b. 30 days
c. 32 days
d. 28 days

4. Which measure expresses Merdana Trading Ltd.’s times-interest-earned ratio?

a. 55 times
b. 20 times
c. 34 times
d. 32 times

5. Merdana Trading Ltd.’s rate of return on equity can be described as?

a. 33.55%
b. 16.72%
c. 35.29%
d. None of the above

6. Merdana Trading Ltd.’s rate of return on asset can be described as?

a. 33.55%
b. 16.72%
c. 35.29%
d. None of the above

7. Merdana Trading Ltd.’s gross profit rate can be described as?

a. 34%
b. 19%
c. 20%
d. 66%
II. Problems solving

Problem 1:
Very Berry Company
Statement of Comprehensive Income
For the Year-ended December 31
 2018 2019
Sales 10,040,000 8,760,000
Cost of Goods Sold 5,680,000 5,860,000
Gross Profit 4,360,000 2,800,000
Operating Expenses 1,160,000 1,680,000
Operating Income 3,200,000 1,220,000
Interest Expense 100,000 28,000
Net Income 3,1000,000 1,192,000

Very Berry Company

Statement of Financial Position
For the Year-ended December 31

2018 2019
Cash 400,000 180,000
Short-term investments 5,600,000 1,800,000
Accounts receivable 1,480,000 1,060,000
Inventory 1,380,000 1,640,000
Other Current Assets 8,860,000 4,680,000
Total Current Assets 10,860,000 5,040,000
Equipment 6,800,000 5,200,000
Total Assets 17,660,000 10,240,000
Accounts Payable 6,600,000 2,620,000
Notes Payable - long term 2,460,000 2,120,000
Owner, Capital 8,600,000 5,500,000
Total liabilities and equity 17,660,000 10,240,000

Requirements:
a. Compute for the company’s profitability ratios for 2019.
b. Compute for the liquidity and solvency ratios of the company in 2018 and 2019.
 Answer Key

Answer Key
What I know

1. C
2. B
3. A
4. B
5. B
6. A
7. B
8. A

1. T
2. F
3. F
4. T
5. F
6. D
7. E
8. E
9. C
10. D

What I have learned

1. Liquidity - the ability of the company to settle its current obligations as they
fall due.
2. Liquidity Ratios
 Current Ratio = Current Assets

Current Liabilities

Quick Ratio =Cash + Short Term Investment + Trade Receivables

Current Liabilities

Receivable Turnover = Net Credit Sales

Average Trade Receivable

Average Trade Receivable =Beginning Trade Receivable + Ending Trade Receivable

2
 Average Collection Period = 360 Days

Trade Receivable Turnover

Inventory Turnover = Cost of Goods Sold

Average Inventory

Average Inventory = Beginning Inventory + Ending Inventory

Average Sales Period = 360 days

Inventory Turnover

Working Capital = Current Assets – Current Liabilities

3. Solvency - the ability of the company to settle its non-current or long term

obligations and the interest related to these obligations.

4. Solvency Ratios

1. Debt Ratio = Total Liabilities

Total Assets

2. Equity Ratio = Total Equity

Total Assets

3. Debt to Equity Ratio = Total Liabilities

Total Equity
4. Times Interest Earned = Income before Interest and Taxes
Interest Expense

5. Profitability – measures the company’s operating performance as a return on

its investment. It gauges management efficiency in using company resources
in order to generate revenue.

6. Profitability Ratios
1. Gross Profit Ratio = Gross Profit
Net Sales
2. Operating Profit Margin = Operating Income
Net Sales

3. Net Profit Margin = Net Income

Net Sales

4. Return on Assets = Net Income

Average Total Sales
Average Total Assets = Assets at Beginning of the Year + Assets at Ending of the
Year

What I can do

1. Identify the type of ration given in each number. Write the letter of the correct
answer on the blank provided.

a. Liquidity Ratio b. Solvency Ration c. Profitability Ratio

1. Debts to Equity Ratio B

2. Inventory Turnover A

3. Average Sales Period A

4. Return on Assets C

5. Working Capital A

6. Times Interest Earned B

7. Gross Profit Ratio C

8. Current Ratio A

9. Average Collection Period A

10. Operating Profit Margin C

11. Equity Ratio B

12. Quick Ratio A

13. Debt Ratio B

14. Net Profit Margin C

15. Receivable Turnover A

2. Listed below are ratios for 2016 and 2017. Identify whether the change in the
ratio value is favorable or unfavorable by stating the general rules

1. Favorable
2. Unfavorable
3. Favorable
4. Unfavorable
5. Favorable
6. Favorable
7. Favorable
8. Unfavorable
9. Favorable
10. Unfavorable
11. Unfavorable
 12. Favorable
13. Unfavorable
14. Favorable

Assessment

Current Ratio = Current Assets

Current Liabilities

524000 1.84507

284000

Quick Ratio = Cash + Short Term Investment + Trade Receivables

Current Liabilities

58000+228000 342000 1.2042

284000 284000

Receivable Turnover = Net Credit Sales

Average Trade Receivable

1716000 8.62312 times

199000

Average Trade Receivable Beginning Trade Receivable + Ending Trade Receivable

228000+170000 398000 199000

22

Average Collection Period = 360 Days

Trade Receivable Turnover

360 41.748 days

8.623115578

Inventory Turnover = Cost of Goods Sold

Average Inventory

1026000 4.58036 times

224000

Average Inventory = Beginning Inventory + Ending Inventory

22600+222000 448000 224000

22

Average Sales Period = 360 Days

Inevntory Turnover

360 78.5965 days

4.58036

Working Capital = Current Assets – Current - Liabilities

524000-284000

240000

Debt Ratio = Total Liabilities 862000 0.5476

Total Assets 1574000

Equity Ratio = Total Equity 712000 0.4524

Total Assets 1574000

Debt to Equity Ratio = Total Liabilities 862000 1.2107

Total Equity 712000

Times Interest Earned = Income before Interest and Taxes

Interest Expense

202000 5.05 times

40000
Gross Profit Ratio = Gross Profit 690000 0.4021

Net Sales 1716000

Operating Profit Margin = Operating Income 202000 0.117716

Net Sales 1716000

Net Profit Margin = Net Income 96000 0.055944

Net Sales 1716000

Return on Assets = Net Income 96000

Average Total Sales 1716000+1606000

96000 0.028898

3322000

Average Total Assets = Assets at Beginning of the Year + Assets at Ending of the Year

1574000 1288000+1574000

2862000 1431000

2
 Additional Activities
1. C
2. A
3. B
4. B
5. A
6. B
7. D

Problem 1: Very Berry Company

Profitability ratio

Gross Profit Ratio 43.43%

Operating income margin 31.87%
Net profit margin 30.88%
Return on Assets
NI/Total Assets 17.55%
EBIT/Total Assets 18.12%
NI/Average Assets 22.22%
EBIT/Average Assets 22.94%
Return on Equity
NI/Total Equity 36.05%
 NI/Average Equity 45.39%

Asset Turnover 0.72

Fixed Asset Turnover 1.67
Inventory Turnover 3.76
Days in Inventory 97.03
AR Turnover 7.91
Days in AR 46.17

Liquidity
Debt to equity 1.053488372 0.861818182
Debt ratio 0.513023783 0.462890625
Equity ratio 0.486976217 0.537109375
Interest Coverage 32 43.57142857

Solvency
Current ratio 1.645454545 1.923664122
Quick ratio 1.13333333 1.160305344

References

1. Haddock, M., Price, J., & Farina, M. (2012). College Accounting: A Contemporary
Approach, Second Edition. New York: McGraw-Hill/Irwin.
2. Valencia, E. G., &Roxas, G. F. (2010). Basic Accounting (3rd ed.).
Mandaluyong City,
Philippines: Valencia Educational Supply.
3. Flocer Lao Ong, Janelle Goemdoza (2017). Fundamentals of Accountancy, Business
and
Management 2 (First Edition), South Triangle, Quezon City

4. https://www.slideshare.net/MykelAlon/fundamentals-of-accountancy-business-and-
management-2

5. https://courses.lumenlearning.com/sac-finaccounting/chapter/exercises-unit-18/

6, https://www.accountingcoach.com/financial-ratios/quiz
For inquiries or feedback, please write or call:

Department of Education – (Bureau/Office)

(Office Address)

Telefax:

Email Address: