FINANCIAL RATIOS

FINANCIAL RATIO

• tools for analyzing the

financial health of the
company
 RATIO ANALYSIS

• Ratio analysis is the process of

determining and interpreting numerical
relationship based on financial statements.
• It is the technique of interpretation of
financial statements with the help of
accounting ratios derived from the balance
sheet and profit and loss account.
 FINANCIAL MIX RATIO ANALYSIS

•is an analytical tool employing the

ratio or proportion of a certain item in
the financial statement vis-à-vis other
related items in the same financial
statement or other statements to
determine comparative performance.
 USE OF FINANCIAL RATIOS

•The use of financial ratios is a time-

tested method of analyzing a business.
Business owners use financial ratio
analysis to learn more about a
company’s current financial health as
well as its potential.
 Types of Ratios

As you use this guide you will become

familiar with the following types of ratios:
• Liquidity ratios
• Solvency or stability ratios
• Profitability ratios
 LIQUIDITY RATIOS

•are group of ratios that measure the

ability of the business firm to pay off
short-term obligation as they
mature.
•These ratios show the relationship of
the firm’s current assets to current
liabilities
 CURRENT ASSET & CURRENT LIABILITIES

• Current asset are assets that are used,

consumed, or sold within one year or within the
normal operating cycle of the business.
• While current liabilities are liabilities expected
to be settled within 12 months after the date of
the statement of financial position (balance
sheet)
 COMPOSITION OF LIQUIDITY RATIOS
1.Current Ratio – indicates the extent to which the
current liabilities are covered by the current asset.
This is the most commonly used to measure short-
term solvency because it serves as a single indicator
of the extent to which the claims of short-term
creditors are covered by the current assets. It is a
reflection of financial strength.
Formula:
Current ratio = Current Asset / Current Liabilities
Ideal ratio: 2.7:1
High ratio indicates under trading and over capitalization.
Low ratio indicates over trading and under capitalization.
 Current Ratio – Illustration: Required: Compute the current ratio and make a simple analysis of the result

YVONE MERCHANDISING
Comparative Statement of Financial Position
December 3, 2017 and 2018

Current Assets 2018 2017

Cash and Cash Equivalents 7,500 10,000
Trade and other receivables 113,500 138,000
Inventory 302,000 238,000
Prepaid expenses 10,000 7,500
Total current assets 433,000 393,500
Non-current assets
Property, plant and equipment 1,500,000 1,112,500
Investment in stocks 500,000 500,000
Total non-current assets 2,000,000 1,612,500
Total assets 2,433,000 2,006,000
Current Liabilities
Trade and other payables 118,500 104,500
Other current liabilities 50,000 42,500
Total current liabilities 168,500 147,000
Non-current liabilities
Bonds payable - 10% 500,000 500,000
Total liabilities 668,500 647,000
Owner's equity
Yvone, Capital 1,764,500 1,359,000
Total Liabilities and owner's equity 2,433,000 2,006,000
 Answer:

The current ratiod for the year ended 2018 and 2017:
2018 433,000 = 2.57:1.00
168,500

2017 393,500 = 2.68:1.00

147,000
 Analysis:
• In year 2017, the current ratio of 2.68:1.00 indicates
that for every P1.00 current liability, the company has
an available amount of P2.68 current assets. 
• In year 2018, the current ratio of 2.57:1.00 indicates
that the business appear to be liquid since it has more
current asset to settle its current liabilities.
• However, the decrease of current ratio from 2.68 to
2.57 may appear to be unfavorable trend since the
increase in current liabilities is faster than current
assets.
 COMPOSITION OF LIQUIDITY RATIOS

2. Quick Ratio or Acid-test Ratio– is more stringent measure

of the liquidity status of a business firm since some current
assets are not included in the computation. Quick Asset
include only the following: cash, trading securities, and
trade receivables. Trading securities and trade receivables are convertible
easily into cash without reducing much the value of the assets.
Quick assets = Cash + Trading Securities + Trade receivables
Formula:
Quick ratio or acid-test ratio= Quick Asset / Current Liabilities

Ideal ratio: 1:1

Usually, a high acid test ratio is an indication that the firm is liquid and has ability to meet its current or liquid
liabilities in time and on the other hand a low quick ratio represents that the firm’s liquidity position is not good.
 Quick Ratio – Illustration: Compute the quick ratio for two years and make simple analysis.

YVONE MERCHANDISING
Comparative Statement of Financial Position
December 3, 2017 and 2018

Current Assets 2018 2017

Cash and Cash Equivalents 7,500 10,000
Trade and other receivables 113,500 138,000
Inventory 302,000 238,000
Prepaid expenses 10,000 7,500
Total current assets 433,000 393,500
Non-current assets
Property, plant and equipment 1,500,000 1,112,500
Investment in stocks 500,000 500,000
Total non-current assets 2,000,000 1,612,500
Total assets 2,433,000 2,006,000
Current Liabilities
Trade and other payables 118,500 104,500
Other current liabilities 50,000 42,500
Total current liabilities 168,500 147,000
Non-current liabilities
Bonds payable - 10% 500,000 500,000
Total liabilities 668,500 647,000
Owner's equity
Yvone, Capital 1,764,500 1,359,000
Total Liabilities and owner's equity 2,433,000 2,006,000
 Illustration:

2018 2017
Cash and Cash Equivalents 7,500 10,000
Trade and other
receivables 113,500 138,000
Quick assets 121,000 148,000

Quick ratio or acid-test ratio =

2018 121,000 / 168,500 = 0.72:1
2017 148,000 / 147,000 = 1.01:1
 Analysis:

• The business has a current ratio of 2.57 but it

has quick ratio of 0.72 in 2018. This result
clearly indicates that the business has a
significant amount of resources in inventory.

• The quick ratio of the business has dropped in

2018 from P1.01 to P0.72 for every P1.00
current liability. This trend is usually considered
unfavorable.
Why inventory and prepaid expenses are excluded in
the quick ratio?

• Inventory is excluded in the computation of quick

ratio because it is the least liquid of a firm’s current
assets and their losses are most likely to be
incurred at the time of liquidation.
• While, prepaid expenses are also excluded
because it represent future obligation and the
possibility of converting the items into cash is very
slim.
 COMPOSITION OF LIQUIDITY RATIOS

3. Receivable Turnover– measures the velocity of conversion of trade

receivables into cash during the year. It answer the question: How
many times during the year has a receivable been converted into cash?
Considered as an asset management ratio since it measures the
effectiveness of the management in handling its resources and
efficiency of the collection effort and credit policy of the business
Formula:
Receivable Turnover = Net Credit Sales/Average trade receivable
Average trade receivable = Receivable beg. + Receivable end
2
 Receivable Turnover –cont.

• In computing receivable turn-over, the amount of

receivable should be net of allowance for doubtful
accounts.
• In case the data on net sales is not provided, the data
on gross sales may be used to compute the turnover.

• Generally, it is favorable for the business to have a high

receivable turnover. However, a very high or low
receivable turnover may not favorable indicator of the
liquidity status.
 Illustration:
2018 2017
Sales 1,635,000 1,457,500
Trade & other receivable 113,500 138,000

Required:
• Get the receivable turnover for year 2018 & 2017.
 Answer:
for 2018= 1,635,000
(113,500 + 138,000) / 2
= 1,635,000
251,500 / 2
= 1,635,000
125,750
= 13.00
for 2017= 1,457,000
138,000
= 10.56
 Analysis:

In 2018, Yvone Merchandising converted its

receivable into cash 13 times during the year
against 10.56 times in 2017. This may indicate two
tendencies:
a. First, the quality of receivable may have
improved which means that good credit policy may
have been adopted.
b. Second, the company may have instituted a
better collection strategy, or has selected a good
 COMPOSITION OF LIQUIDITY RATIOS

4. Inventory Turnover– measures the number of times

inventories are acquired and sold during the year. In a typical
situation, profits are realized from sale of inventories; hence
the faster the sale of goods, the higher is the profit.
Formula:
Inventory Turnover = Cost of Goods Sold/Average Inventory
Average inventory = Inventory beg. + Inventory end
2
High inventory turnover is favorable to the business.
 Illustration:

2018 2017
IInventory 302,000 238,000
Cost of sales 1,050,000 950,000

Required:
Get the inventory turnover for year 2018 & 2017
 Answer:
for 2018 = 1,050,000
(302,000 + 238,000 ) / 2

= 1,050,000
540000 / 2

= 1,050,000
270,000

= 3.89

for 2017 = 950,000

238,000

= 3.99
 Analysis:
The results of the computation may indicate the following:
1.The inventory turnover in 2017 of 3.99 times may indicate
better performance in the conversion of inventory into cash
compared to the operating performance in 2018 with 3.89
times.
2.It may appear that it takes basically almost 4 months for the
business to convert inventories into cash in 2017, and more
that 4 months in 2018.
3.The business may appear to be selling and buying goods
that are not considered fast moving items similar to the
items sold in the supermarket.
 Types of Ratios

SOLVENCY RATIOS
• Known as the stability ratio
• Group of financial ratios that measure the ability of a
business to settle its financial obligation when they
mature and to remain still financially stable.
• A business with favorable solvency ratios appears to
have most of the funds provided by the owners instead
of the creditors.
 RATIOS UNDER SOLVENCY
FINANCIAL LEVERAGE RATIOS – that reflect the extent to
which a firm utilizes debt financing.
Two concept of leverage or an act of increasing from current status:
a. Operating leverage – affects the short-term investment and non-
current assets of an entity or the left-hand side of the statement of
financial position. Its concerned with fixed cost influences the
operations of the company.
b. Financial leverage – primarily affects the right-hand side of the
statement of financial position or the short-term debt, long-term
debt, and owner’s equity. It reflects the amount of debts utilized in
the capital structure of the business firm.
 COMMON FINANCIAL LEVARAGE RATIOS
1.DEBT RATIO – measures the proportion of funds provided by the
creditors on the total resources of the business. This ratio reflects the
percentage of the total assets that are financed with debt or by the
creditors. Its answer the question: Of the total resources, how much is
provided by the creditors?
Creditors prefer low debt ratio because their investments are generally
protected by higher proportion of owners’ funds in the event of liquidation.
On the other hand, most owners prefer to have high leverage because it will
improve the expected return on their investment.
FORMULA:
DEBT RATIO = Total Liabilities / Total Assets
Generally, a debt ratio of 50% debt and 50% equity is considered the fair maximum level for both
creditors and owners.
 COMMON FINANCIAL LEVARAGE RATIOS

2. EQUITY RATIO – determines the proportion of resources provided by

the owner/s of the business. It presents the financial strengths of the
business as it provides the margin of safety that the company affords to
creditors.
A business with high equity ratio, which is normally more than 50% of
the total resources, is considered having favorable financial standing from
the perspective of the creditors.
FORMULA:
EQUITY RATIO = Total Equity / Total Assets or 1 – Debt ratio
 COMMON FINANCIAL LEVARAGE RATIOS

3. DEBT-TO-EQUITY RATIO – measures the proportion of debt and equity

in the capital structure of the business. This measure also indicates
whether the company favor risk in its capital structure or not.
When the debt-to-equity ratio is more than1 or more than 100%, the
company has a riskier capital structure since debts imply payment of
interest. Its indicate that creditors provide more fund to the business that
what is provided by the owner/s. It does not appear very attractive to
conservative creditors most especially if the liquidity status of the business
is not favorable in terms of industry standards.
FORMULA:
DEBT-TO-EQUITY RATIO = Total Liabilities / Total Equity
 COMMON FINANCIAL LEVARAGE RATIOS
4. TIMES INTEREST EARNED (TIE)– is a tool that measures the debt
paying liability of the business. It reflects the degree of protection
provided by an entity to its long-term creditors. It is favorable to
investors if the business firm has higher ratio of TIE.
The computation of TIE is applicable only once the business has an
interest-bearing obligations. The interest usually arises when the obligation
is considered long-term in nature. This measure will test the ability of the
operating activities of the business to cover the amount of interest expense.
In accounting, interest expense is not classified as operating expense. It is
separately presented as financing charges.
FORMULA:
Times Interest Earned = Income before interest and taxes/ Interest
Expense
 Types of Ratios

PROFITABILITY RATIOS
• Are a group of ratios that reflect the combined effects
of liquidity and management efficiency in handling the
assets and liabilities relative to the operations of the
business. The ratios show the effectiveness of the
business operations.
 MEASURES OF PROFITABILITY

1. GROSS PROFIT RATE– measures the percentage of gross profit to sales.

It also measures the percentage of gross profit margin available to cover
the operating expenses for the period. It also reveals the percentage of
cost of sales to sales.
The gross profit or gross margin is the difference between sales and the
cost of sales. Since profit may grow by increasing the selling price or
quantity, or by reducing the cost of selling the product, the gross profit
margin may also indicate the measures adopted by the business to control
the elements affecting sales and cost of sales.
FORMULA:
Gross profit rate = Gross profit / Net Sales
 MEASURES OF PROFITABILITY

2. OPERATING PROFIT MARGIN– measures the percentage of profit

available after deducting the cost of sales and operating expenses from
the sales. It is the difference between the gross profit and the operating
expenses.
This measure reflects the overall efficiency of the management in
handling the production, selling, and administrative costs of the business.
FORMULA:
Operating profit margin = Operating Profit / Net Sales
 MEASURES OF PROFITABILITY

3. NET PROFIT MARGIN– also called return of sales, measures the overall
operating results of an entity. The measures considers all income
recognized and all expenses incurred during the period.
In computing the net profit margin, gain or losses from transactions not
directly related to the normal operations of the business such as sale of
property, plant, and equipment or sales of investments in stock or bonds are
included.
FORMULA:
Net profit margin = Net Income / Net Sales
 MEASURES OF PROFITABILITY
4. RETURN ON INVESTMENT (ROI)– also called return on assets, measures the
amount of net income per peso of investment in a business. The ration reflects
the profitability of every peso invested by the owner.
Higher ROI is generally favorable to the business. However, the industry
average serves as a good benchmark to compare the profitability performance of
the business.
FORMULA:
Return on investment = Net Income / Average total assets
If the business firm has an interest-bearing debt, the amount of interest net of tax
is added back to the net income.
Formula:
Return on investment = Net Income + [Interest (1-Tax rate)]/Average total assets