11 SENIOR HIGH SCHOOL

FABM 2
Quarter 3 – Module 4
The Measurement Levels: Liquidity,
Solvency, Stability, and Profitability

NegOr_Q3_FABM211_Module4_v2
FABM 2 – Grade 11
Alternative Delivery Mode
Quarter 3 – Module 4: The Measurement Levels: Liquidity, Solvency, Stability,
and Profitability
Second Edition, 2021

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NegOr_Q3_FABM211_Module4_v2
Introductory Message

This Self-Learning Module (SLM) is prepared so that you, our dear

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Thank you.

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 I

This module was designed to provide you with fun and meaningful opportunities for
guided and independent learning at our own pace and time. You will be enabled to process the
contents of the learning resource while being an active learner.

Now, in this lesson we will completely focus on the measurement levels, namely,
liquidity, solvency, stability and profitability and we will demonstrate an understanding of the
importance of identifying this after.

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 I

Pre-assessment:
Directions: Tell whether the following statements given below is a liquidity ratio,
profitability ratio, and solvency ratio. Write the letter of the correct answer in your activity
notebook.

a. Liquidity ratio c. Solvency ratio

b. Profitability ratio

1. Working Capital
2. Current Ratio
3. Acid Test Ratio
4. Gross Profit Ratio
5. Accounts Receivable Turnover Ratio
6. Debt to Total Assets Ratio
7. Debt to Equity Ratio
8. Times Interest Earned Ratio
9. Profit Margin Ratio
10. Inventory Turnover Ratio
11. Operating Expenses to Sales Ratio
12. Return on Investment
13. Average Collection Period
14. Asset Turnover Ratio
15. Average Days in Inventory

’s In

Task 1
Recall our previous lesson.
Let us recall what you have learned in our previous lesson by answering the following questions
in your activity notebook.

1. What are the contents of the financial statement?

a. _____________________________________________
b. _____________________________________________
c. _____________________________________________
d. _____________________________________________

2 NegOr_Q3_FABM211_Module4_v2
 e. _____________________________________________

2. What are the three major sections in the Statement Cash Flow?
a. _____________________________________________
b. _____________________________________________
c. _____________________________________________
3. How is this related in our new lesson?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
______________.

’s New

Task 2

In your barangay/municipality, give at least three examples of businesses which you

think are very profitable and three examples of businesses that you think are not profitable.
Answers can range from specific company names to general types of business.

Answer the following questions in your activity notebook.

1. Discuss and reflect why businesses have different levels of profitability?

2. If the business is profitable could we say that it is liquid, solvent and stable business?
Why?

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 is It

Measurement Levels

Financial ratios are one of the most common tools of managerial decision making. A
ratio is a comparison of number to another-mathematically, a simple division problem.
Financial ratios involve the comparison of various figures from the financial statements in order
to gain information about a company’s performance.

It is the interpretation, rather than the calculation, that makes financial ratios a useful
tool for business managers. Ratios may serve as indicators, clues, or red flags regarding
noteworthy relationships between variables used to measure the firm’s performance in terms
of profitability, asset utilization, liquidity, leverage, or market valuation.

Different Financial Ratios

I. Liquidity Ratios

Liquidity is the capacity of company to pay its currently maturing obligations. This
will require a good amount of Cash and other liquid assets such as Accounts Receivable,
Inventory, Trading Securities, and Prepaid Assets.
These ratios are very important to short term creditors of a company. These ratios will
determine if the borrowing company is in a position to pay the borrowed principal and
interest when they fall due.
A good liquidity position would encourage banks or financial institutions to lend
while a bad liquidity position may scare off potential creditors.

The following are the different liquidity ratios:

a. Working Capital
Working capital is the difference between current assets and current liabilities.
This is one of the simplest liquidity ratios. A positive working capital is preferred
because it would mean that there are enough current assets to pay all of the current
liabilities at the moment. On the other hand, a negative working capital is to be
avoided because it would mean that the company will surely default on some of their
liabilities.

b. Current Ratio
Current ratio is the quotient of current assets divided by current liabilities. As
much as possible, a “whole number” current ratio is preferred.

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c. Acid Test Ratio
Acid Test Ratio is a more strict variation of the current ratio formula. It
removes Inventory and Prepaid Expenses from the numerator. Only Cash,
Receivables, and Trading Securities (also known as Quick Assets) will be left.
Generally, Quick Assets are more liquid than Inventory and Prepaid Expenses. As
much as possible, a whole number acid test ratio should be desired by companies.

d. Accounts Receivable Turnover Ratio

This ratio measures the frequency of conversion of the company’s Accounts
Receivable to Cash. It measures how many times the company was able to collect its
Accounts Receivable from its customers.

e. Average Collection Period

The average collection period states the usual number of the days that it would
take before the company would be able to collect a certain group of receivables. This
ratio is usually connected with the previous A/R Turnover Ratio. In fact, the A/R
Turnover Ratio itself is a component for the computation of the average collection
period.
f. Inventory Turnover Ratio
This ratio measures the number of times the company was able to sell its entire
inventory to customers during the year. As much as possible, the goal is to have a
high inventory turnover ratio. By having such, it will mean that the company is being
more effective in selling its inventory to customers.

g. Average Days in Inventory

This ratio computes the number of days that of it will take before a group of
inventory will be entirely sold by the company. This follows the same concept in
computing the average collection period.

h. Number of Days in Operating Cycle

This is the measure on how it will take for the company to transform its inventory
back to cash. This is the combination of the average collection period and the average
age of inventory. The goal is to always have a shorter number of days in the operating
cycle. A shorter number will indicate that the company will have additional cash at an
earlier time.

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 II. Solvency Ratios

Solvency ratios measure the capability of an entity to pay long term obligations as
they fall due. Creditors of the company’s long term notes payable and bonds payable will be
interested in knowing its solvency status. There are at least three kinds of solvency ratios.

a. Debt to Total Assets Ratio

As the term implies, this is just the proportion between the total liabilities of
the company with its total assets. The debt ratio shows how much of the assets of the
company were given by creditors. As much as possible, current and prospective
creditors would want a very low debt to total assets ratio. There is a bigger probability
of collection in the future if there are fewer liabilities to pay.

b. Debt to Equity Ratio

Instead of assets, the debt to equity ratio compares the liabilities of the
company with its equity. A small debt to equity ratio would indicate a healthier
solvency position for the company.

c. Times Interest Earned Ratio

The Times Interest Earned Ratio shows the proportion between the Earnings
before Interest and Taxes (EBIT) of the company and its interest expense. It is an
indicator on how many times the EBIT can cover the finance cost of borrowing.
This is related to the solvency situation of the company because interest
expense is always a part of long term borrowing. Creditors will charge interest during
the time that the loan or borrowing is not yet paid.

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 III. Profitability Ratios

One of the primary reasons why stockholders invest in a certain company is the chance
to earn profits. Investors make use of different profitability ratios in choosing from diverse
investment opportunities available. The absolute value of the net income after tax is not
sufficient basis to determine the earning potential of a certain company. This must be
understood in relation to other items in the financial statements. There are at least five
profitability ratios that can be used.

a. Gross Profit Ratio

As the term implies, this is the proportion of the gross profit of the company
with its net sales. Gross profit is the difference between the next sales of the
company and its cost of goods sold.

b. Profit Margin Ratio

The profit being mentioned here is the Net Income after Tax (NIAT). This
ratio measures the proportion between the NIAT and the net sales of the company.
This is more precise measure of the company’s profitability because it has already
considered the operating expenses and other expenses of the entity.

c. Operating Ratio
Operating expenses, aside from the cost of goods sold, are the biggest
expense group of every company. It can be further classified into General and
Administrative Expenses and Selling Expenses. These expenses are needed to
generate sales for the period.
This ratio can be computed by dividing the operating expenses by the total
net sales.

d. Return on Investment Ratio

The return on investment ratio has two variations. One is the return on assets
and the other is the return on shareholder’s equity. They only differ in the
denominator that is used in the computation.

d.1 Return on Assets

Before profits can be realized, certain investments need to be made. In
this case, assets will be used for the different projects of the company. The goal
is to generate as much profit based on available assets during the year. Thus, a
higher return on assets is to be desired.
To compute for the return on assets, net income after tax is divided by
average total assets for the year. Total assets can easily be computed by adding
the starting and ending balance of assets and dividing it by two.

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 d.2 Return On Equity
This is a slight variation of the earlier formula. In this case, it is the
average stockholder’s equity that will be used as a denominator. This is a more
specific computation of a company’s profitability because the denominator
being used is the equity coming from stockholders only. When computing the
return on assets, the average total assets being used may come predominantly
from creditors. However, the goal is still to have a higher return on equity.

e. Asset Turnover Ratio

This ratio measures the correlation between the assets owned by the
company and the net sales generated by such properties. It can easily be computed
by dividing the net sales during the period by the average total assets for the year.

IV. Stability

Stability is the long-term counterpart of liquidity. Stability analysis investigates

how much debt can be supported by the company and whether debt and equity are
balanced. The most common stability ratios are the Debt-to-Equity ratio and gearing
(also called leverage).

V. Efficiency

Efficiency refers to a company’s ability to be efficient in its operations. Two

common efficiency ratios are, inventory turnover and receivables turnover. Inventory
turnover is the ratio of cost of goods sold to inventory turnover ratio. It means that the
company is successful in converting its inventory into sales. The receivables turnover
ratio is the ratio of credit sales to accounts receivable, which tracks outstanding credit
sales. High accounts receivable turnover means that the company is successful in
collecting its outstanding credit balances.

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 ’s More

Task 3

Directions: Enumerate the different ratios being test in the following financial ratios found in
the table below. Do it in your activity notebook.

Liquidity Ratio Profitability Ratio Solvency Ratio

Task 4

Directions: From the table above that you have completed, why you think it is important for
you to know the different ratios as an ABM student. Do it in your activity notebook.

___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
_______________________.

I Have Learned

Directions: Complete the following statements. Write your statements in your activity
notebook.

1. As an ABM student, I have learned that the Measurement levels in liquidity, solvency,
stability, and profitability are _______________________.

2. As an ABM student, it is very important for us to learn Measurement levels because

_______________________.

3. Using the knowledge I have learned in this lesson, I will be able to...
_______________________.
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 I Can Do

Task 4
Directions: Answer the following questions below. Write your answers on your Activity
Notebook.

As an ABM student, show your own understanding in the discussion guided with the
following questions.

1. What is the difference between liquidity ratio, solvency ratio and profitability ratio?
2. When do we say that the business is stable and efficient? Cite an example.

ESSAY RUBRIC
Level of Achievement General Approach Comprehension
Exemplary •Addresses the question. •Demonstrates an accurate and complete
(15 pts quizzes) •States a relevant, justifiable understanding of the question.
answer. •Backs conclusions with data and
•Presents arguments in a logical warrants.
order. •Uses 2 or more ideas, examples and/or
arguments that support the answer.
Adequate •Does not address the question •Demonstrates accurate but only adequate
(10 pts quizzes) explicitly, although does so understanding of question because does
tangentially. not back conclusions with warrants and
•States a relevant and justifiable data.
answer. •Uses only one idea to support the answer.
•Presents arguments in a logical •Less thorough than above.
order.
Needs Improvement •Does not address the question. •Does not demonstrate accurate
(5 pts quizzes) •States no relevant answers. understanding of the question.
•Indicates misconceptions. •Does not provide evidence to support
•Is not clearly or logically their answer to the question.
organized.
No answer (0 pts)

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I. Directions: Multiple Choice. Identify what is asked in each item. Write the letter of the
correct answer in your activity notebook.
1. This ratio measures the frequency of conversion of the company’s Accounts Receivable
to Cash.
a. Current Ratio c. Average Collection Period
b. Accounts Receivable Turnover Ratio d. Working Capital
2. This ratio measures the number of times the company was able to sell its entire
inventory to customers during the year.
a. Inventory Turnover Ratio c. Acid Test Ratio
b. Average Days in Inventory d. Working Capital
3. This shows the proportion between the Earnings Before Interest and Taxes (EBIT) of
the company and its interest expense.
a. Debt to Total Assets Ratio c. Times Interest Earned Ratio
b. Debt to Equity Ratio d. All of these
4. This ratio measures the correlation between the assets owned by the company and the
net sales generated by such properties.
a. Return on Investment c. Return on Equity
b. Return on Assets d. Asset Turnover Ratio
5. This is the proportion of the gross profit of the company with its net sales.
a. Gross Profit Rati c. Operating Expenses to Sales ratio
b. Profit Margin Ratio d. Return on Investment
6. This refers to both an enterprise’s ability to pay short-term obligations and a
company’s capability to sell assets quickly to raise cash.
a. Liquidity c. Solvency
b. Stability d. Profitability
7. It refers to a company’s ability to meet long-term obligations.
a. Solvency c. Profitability
b. Efficiency d. Stability
8. This ratios measure a company’s ability to generate profits from its resources (assets).
a. Profitability c. Solvency
b. Liquidity d. Stability
9. It is the long-term counterpart of liquidity.
a. Profitability c. Efficiency
b. Stability d. Solvency
10. Which of the following categories of ratios could be used to evaluate a
company’s ability to pay back a bank loan?
a. Liquidity ratios c. Solvency ratios
b. Profitability ratios d. All of these
II. Essay.

1. Why it is important to use profitability ratio, solvency ratio, and liquidity ratio in
the analysis and interpretation of a business’ financial statement? Explain briefly.

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NegOr_Q3_FABM211_Module4_v2 12
What I Know (Pre-assessment)
1. A 6. C 11. B
2. A 7. C 12. B
3. A 8. C 13. A
4. B 9. B 14. B
5. A 10. A 15. A
What’s In (Task 1)
1.a. Statement of Financial Position (Balance Sheet)
b. Statement of Comprehensive Income (Income Statement)
c. Statement of Changes in Equity
d. Statement of Cash Flow
e. Notes, comprising a summary of significant accounting policies and other explanatory information.
2.a. Operating
b. Investing
c. Financing
3. Answer May Vary
What’s New (Task 2)
Answer May Vary
What’s More (Task 3)
Liquidity Ratio Profitability Ratio Solvency Ratio
a. Working Capital a. Gross Profit Ratio a. Debt to Total Assets Ratio
b. Current Ratio b. Profit Margin Ratio b. Debt to Equity Ratio
c. Acid Test Ratio c. Operating Expenses to Sales ratio c. Times Interest Earned Ratio
d. Accounts Receivable Turnover d. Return on Investment
Ratio d. 1 Return on Assets
e. Average Collection Period d. 2 Return on Equity
f. Inventory Turnover Ratio e. Asset Turnover Ratio
g. Average Days in Inventory
h. Number of Days in Operating
Cycle
(Task 4) Answer May Vary
Assessment:
I. Multiple Choice II. Essay
1. B 6. A
2. A 7. A Answer may vary
3. C 8. A
4. D 9. B
5. A 10. C
Glossary
Efficiency - refers to a company’s ability to be efficient in its
operations.
Liquidity – refers to the company’s ability to satisfy its short-term
obligations as they come due.
Stability - is the long-term counterpart of liquidity
Solvency ratios - measure the capability of an entity to pay long term
obligations as they fall due.
Profitability – refers to the company’s ability to generate earnings

References

Angeles A. De Guzman, DBA,CPA. 2018. Fundamentals of Accountancy, Business &

MAnagement 2. Quezon City: LORIMAR Publishing Inc.
Rodriguez, J. A. et al., Business Finance, Teaching Guide for Senior High School. 2016.
Quezon City: Commission on Higher Education.
Encyclopedia.com. Financial Ratios. n.d. Accessed december 15, 2021.
https://www.encyclopedia.com/social-sciences-and-law/economics-business-and-
labor/businesses-and-occupations/ratio-analysis
Monfero, R.P.P. Fundamentals of Accounting, Business and Management 2, Teaching Guide
for Senior High School. 2016. Quezon City: Commission on Higher Education.
Industruscfo.com. Company Financial Statement Analysis & Interpretation of Financial
Statements. n.d. Accessed decemmber 15, 2021.
https://www.industriuscfo.com/company-financial-statement-analysis/.
Beticon, J.L., Domingo, J.C.D., and Fermin Antonio D. Yabut. 2016. Fundamentals of
Accountancy, Business ad Management 2. Quezon City: Vibal Group Inc.

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