Week 7 Date: October 20, 2020

Subject Fundamentals of Accountancy, Business and

Management 2
Type of Activity Concept Notes and Exercise
Activity Title Financial Ratios: Liquidity Ratios
Learning Target Compute the different liquidity ratios and
interpret the results if it has improved from
the previous year.
Reference Title Fundamentals of Accountancy, Business and
Management 2
Author/s Josefina Loria Beticon, CPA, et. al
Financial Ratio
Analysis
 Financial Ratio Analysis
Investors and analysts employ financial ratio analysis to evaluate the
financial health of companies by scrutinizing past and current financial
statements.
 Financial Ratio Analysis
Determining individual financial ratios per period and tracking the change in
their values over time is done to spot trends that may be developing in a
company.
For example, an increasing debt-to-asset ratio may indicate that a company is
overburdened with debt and may eventually be facing default risk.

 Example:

Year 1 Year 2
Total Debts: 500,000 Total Debts: 900,000
Total Assets: 1,000,000 Total Assets: 1,000,000
DTAR = DTAR=
DTAR = 0.5 DTAR = 0.9
 Financial Ratio Analysis
Comparing financial ratios with that of major competitors is done to identify
whether a company is performing better or worse than the industry average.

For example, comparing the return on assets between companies helps an

analyst or investor to determine which company is making the most efficient
use of its assets.

 Example:

Company A Company B
Net Income: 1,750,000 Net Income: 1,400,000
ATA: 2,000,000 ATA: 2,200,000
ROA = ROA=
ROA = 0.875 ROA = 0.6364
 Financial Ratio Analysis
Financial ratios in accounting can be classified into three groups:
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios

Profitability Ratio
Liquidity Ratios
 Liquidity Ratios
• Liquidity ratios are an important class of financial metrics used to
determine a debtor's ability to pay off current debt obligations without
raising external capital.
• These would require a good amount of Cash and other liquid assets like
Accounts Receivable, Inventory, Trading Securities and Prepaid Assets.
• A good liquidity position would encourage banks or financial institutions to
lend while a bad liquidity position may scare off potential creditors.
 Liquidity Ratios
• The following are the different liquidity ratios:
A. Working Capital
B. Current Ratio
C. Acid Test Ratio
D. Accounts Receivable Turnover Ratio
E. Average Collection Period
F. Inventory Turnover Ratio
G. Average Days in Inventory
H. Number of Days in Operating Cycle
 Working Capital
• Is the difference between Current Assets and Current Liabilities.
• A positive working capital is preferred because it would mean that there is
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 would surely default on some of their
liabilities.
 GHI COMPANY
Comparative Statement of Financial Position
For the Year 2018 and 2019
Assets 2018 2019
Cash 400,000 450,000
Accounts Receivable 250,000 280,000
Trading Securities 120,000 30,000
Inventories 370,000 420,000
The financial
Prepaid Expenses 20,000 80,000
statements of the year
Total Current Assets 1,160,000 1,260,000
2018 and 2019 for GHI
Company will be used Total Non-Current Assets 840,000 1,140,000
as the sample data for Total Assets 2,000,000 2,400,000
the illustrative
examples: Liabilities
Total Current Liabilities 400,000 450,000
Total Non-Current 1,100,000 1,300,000
Liabilities
Owner’s Equity
Total Owner’s Equity 500,000 650,000
Total Liabilities & OE 2,000,000 2,400,000
 GHI COMPANY
Comparative Statement of Comprehensive Income
For the Year 2018 and 2019

2018 2019
The financial Net Sales 5,200,000 6,000,000
statements of the year Cost of Sales (1,200,000) (1,500,000)
2018 and 2019 for GHI Gross Profit 4,000,000 4,500,000
Company will be used Operating Expenses (1,000,000) (500,000)
as the sample data for Operating Income 3,000,000 4,000,000
the illustrative Interest Expense (500,000) (2,000,000)
examples: Net Income Before Tax 2,500,000 2,000,000
Income Tax Expense (750,000) (600,000)
Net Income After Tax 1,750,000 1,400,000
Working Capital

Example:

Year 2018
Current Assets 1,160,000
Less: Current Liabilities (400,000)
Working Capital 760,000

Year 2019
Current Assets 1,260,000
Less: Current Liabilities (450,000)
Working Capital 810,000

• For both periods, the company has a positive working capital. This is something good.
• But comparing the two periods together, we can conclude that the company is in a
better liquidity position (working capital wise) in 2019 than in 2018.
 Current Ratio
• Is the quotient of Current Assets divided by the Current Liabilities.
• For example, a current ratio of 3 would mean that the company has ₱3
worth of current assets for every ₱1 of current liabilities. It means that
there would be ₱2 left after the payment of currently maturing obligations.
Current Ratio
Example:
Year 2018
Current Assets 1,160,000
Divided by: Current Liabilities ÷ 400,000
Current Ratio 2.9

Year 2019
Current Assets 1,260,000
Divided by: Current Liabilities ÷ 450,000
Current Ratio 2.8

• It can be seen that the company has whole number current ratios for the two
periods. This is something positive.
• Comparing the two periods together, the company has a better current ratio in 2018
than in 2019.
 Acid Test Ratio
• Is the quotient of Quick Assets divided by the Current Liabilities.
• Quick Assets = Cash + Accounts Receivables + Trading Securities
Acid Test Ratio
Example:

Year 2018
Quick Assets 770,000
Divided by: Current Liabilities ÷ 400,000
Quick Ratio 1.925

Year 2019
Quick Assets 760,000
Divided by: Current Liabilities ÷ 450,000
Quick Ratio 1.689

• It should be noted that the company has positive acid test ratios for the two years
concerned. It means that it really has the capability to pay its currently maturing
obligations thru its quick assets.
• Comparing the two periods together, the company has a better current ratio in 2018
than in 2019.
 
Accounts Receivable Turnover Ratio
• Is the quotient of Net Credit Sales (Total Net Sales) divided by the Average
Accounts Receivable.
• Average Accounts Receivable =
• Beginning accounts receivable is the ending accounts receivable of the
previous year.
Accounts Receivable Turnover Ratio
Example:

Year 2018
Net Sales 5,200,000
Divided by: Average A/R ÷ 250,000
A/R Turnover Ratio 20.80 times

Year 2019
Net Sales 6,000,000
Divided by: Average A/R ÷ 265,000
A/R Turnover Ratio 22.64 times

• Comparing the computed A/R Turnover ratios for the two years, it can be seen that
the company has a higher ratio for 2019. This can be attributed to a better
performance from its collection department.
 
Average Collection Period
• States the usual number of 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 Accounts Receivable Turnover Ratio.
In fact, the A/R Turnover Ratio itself serves as the denominator in the
formula.
• For the numerator, the company makes use of either 360 or 365 days. This
would depend on the policy of the company.
Average Collection Period (in days) =

• As much as possible, the goal is to have a shorter average collection period.

This would mean that the company is efficient in collecting their
outstanding Accounts Receivable from their customers.
Average Collection Period
Example:

Year 2018
Assume 365 days 365
Divided by: A/R Turnover Ratio ÷ 20.80
Average Collection Period 17.55 days

Year 2019
Assume 365 days 365
Divided by: A/R Turnover Ratio ÷ 22.64
Average Collection Period 16.12 days

• By showing a shorter average collection period for 2019, it would mean that the
collection department has increased its efforts to collect the company’s receivables
as they fall due.
 
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 would mean that the company is being more effective in selling its inventory
to customers.
• Unsold goods for a long period of time may lead to inventory obsolescence. This
would also tie up the company’s cash resources to its inventory.
• The numerator for this formula would be the company’s Cost of Goods Sold/Cost of
Sales divided by the Average Inventory.
Inventory Turnover Ratio =
Average Inventory =
• Beginning inventory is the ending inventory of the previous year.
Inventory Turnover Ratio
Example:

Year 2018
CGS 1,200,000
Divided by: Average Inventory ÷ 370,000
Inventory Turnover Ratio 3.24 times

Year 2019
CGS 1,500,000
Divided by: Average A/R ÷ 395,000
Inventory Turnover Ratio 3.80 times

• It can be seen in our computation that the inventory turnover increased for the year
2019. It means that the Sales Department was able to push their products more to
their customers.
 
Average Days in Inventory
• States the number of days that it would take before a group of inventory
will be entirely sold by the company.
• This ratio is usually connected with the Inventory Turnover Ratio. In fact,
the Inventory Turnover Ratio itself serves as the denominator in the
formula.
• For the numerator, the company makes use of either 360 or 365 days. This
would depend on the policy of the company.
Average Days in Inventory (in days) =

• The goal is to have a shorter average days in inventory. A shorter amount

would mean that the cash of the company is not being tied to its inventory
for a very long period of time.
Average Days in Inventory
Example:

Year 2018
Assume 365 days 365
Divided by: Inventory Turnover ÷ 3.24
Average Days in Inventory 112.65 days

Year 2019
Assume 365 days 365
Divided by: Inventory Turnover ÷ 3.80
Average Days in Inventory 96.05 days

• The average days in inventory of this company improved in 2019. This is due to the
fact that the inventory turnover ratio for 2019 also improved.
 Number of Days in Operating Cycle
• This is the measure on how long it would 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/Average Days in Inventory.
• The goal is to always have a shorter number of days in operating cycle. A
shorter number would indicate that the company would have additional
cash at an earlier time.

# of Days in Operating Cycle = Average Collection Period + Average Days in Inventory

Number of Days in Operating Cycle
Example:
Year 2018
Average Collection Period 17.55 days
Average Days in Inventory + 112.65 days
# of Days in Operating Cycle 130.2 days

Year 2019
Average Collection Period 16.12 days
Average Days in Inventory + 96.05 days
# of Days in Operating Cycle 112.17 days

• A comparison between the two periods will show that there was an improvement of
at least 18 days in their operating cycle. It means that the company improved as a
whole when it comes to selling their products and collecting their receivables.
 Exercise
(JK L Company)
 JKL COMPANY
Comparative Statement of Financial Position
For the Year 2018 and 2019
Assets 2018 2019
Cash 290,000 400,000
Accounts Receivable 120,000 100,000
Trading Securities 40,000 20,000
Inventories 60,000 80,000
JKL Company was
Prepaid Expenses 10,000 20,000
established on January
Total Current Assets 520,000 620,000
1, 2018 and is engaged
in the manufacture of Total Non-Current Assets 200,000 300,000
clothes and other Total Assets 720,000 920,000
apparel. The company
makes use of 365 days Liabilities
in its computation for Total Current Liabilities 100,000 50,000

some of the ratios. Total Non-Current 300,000 450,000

Liabilities
Owner’s Equity
Total Owner’s Equity 320,000 420,000
Total Liabilities & OE 720,000 920,000
 JKL COMPANY Requirements: Compute for the
Comparative Statement of Comprehensive Income
For the Year 2018 and 2019 following ratios for the year 2019.
Show your solution:
2018 2019
1. Working Capital
Net Sales 700,000 900,000
2. Current Ratio
Cost of Sales (100,000) (80,000)
3. Quick Ratio
Gross Profit 600,000 820,000
4. Average Accounts
Operating Expenses (50,000) (120,000)
Receivable
Operating Income 550,000 700,000
5. A/R Turnover Ratio
Interest Expense (10,000) (50,000)
6. Average Collection Period
Net Income Before Tax 540,000 650,000
7. Average Inventory
Income Tax Expense (162,000) (195,000)
8. Inventory Turnover Ratio
Net Income After Tax 378,000 455,000
9. Average Days in Inventory
10. Number of Days in the
Operating Cycle