Analysis and

Interpretation
of Financial
Statements
Learning Competency
 define the measurement levels, namely,
liquidity, solvency, stability, and
profitability ABM_FABM12-Ig-h12
 Financial ratios are the most common tools of
managerial decision making. A ratio is a comparison of one
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.
MEASUREMENT LEVELS:
LIQUIDITY
Liquidity is a measure of the ability of a debtor to pay their
debts as and when they fall due. It is usually expressed as a
ratio or a percentage of current liabilities. Liquidity is the ability
to pay short-term obligations. The most common liquidity ratio is
the current ratio which is the ratio of current assets to current
liabilities. This ratio indicates a company’s ability to pay its short
term bills.
Different ratios under liquidity ratio are shown
below:

1. Working Capital- the working capital measures a

firm’s ability to pay off its current liabilities with current
assets. The working capital is important to creditors
because it shows the liquidity of the company.

Working Capital = Current Assets- Current Liabilities

Illustration
2017 (ABC Co.)
Current Assets 1,160,000
Less: Current Liabilities (400,000)
Working Capital 760,000

2018 (ABC Co.)

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.
However, comparing the two periods together,
we can conclude that the company is in a
better liquidity position in 2018 than in 2017.
2. Current Ratio- is a liquidity and efficiency ratio
that measures a firm’s ability to pay off its short-
term liabilities with its current assets. The current
ratio is an important measure of liquidity because
short-term liabilities are due within the next year.

FORMULA: Current Ratio = Current Assets/ Current

Liabilities
Illustration

Ding’s Clothing Store is applying for a loan to

remodel the storefront. The bank asks Ding for a
detailed statement of financial position, so it can
compute the current ratio. Ding’s statement of
financial position included the following accounts:
Cash............................................................10,000
Accounts
Receivable….....................................5,000
Inventory…....................................................5,000
Stock Investments….......................................1,000
Prepaid Taxes...................................................500

Current Liabilities… ......................................15,000

Current Ratio = 10,000+ 5,000+
5,000+ 1,000+ 500/15,000= 1.43
Current Ratio = 10,000+ 5,000+
5,000+ 1,000+ 500/15,000= 1.43
Ding’s current ratio of 1.43 means that the
store is liquid, considering it can pay off all the
current liabilities with current assets and still
have some current assets left over.
3. Quick Ratio (Acid -test ratio)- the quick ratio
or acid test ratio is a liquidity ratio that measures the
ability of a company to pay its current liabilities
when they come due with only quick assets. Quick
assets are current assets that can be converted into
cash within 90 days or in the short-term. Cash, cash
equivalents, short term investments or marketable
securities, and current accounts receivable are
considered quick assets.
FORMULA: Quick Ratio = Cash + cash equivalents
+ Short Term Investments + Current Accounts
Receivables/ Current Liabilities

Illustration
Suppose Tea’s Clothing Store is applying for a loan to
remodel the storefront. The bank asks Tea for a detailed
statement of financial position, so it can compute the quick
ratio. Tea’s statement of financial position included the
following accounts:
Cash 10, 000
Accounts Receivable 5, 000
Inventory 5, 000
Stock Investments 1, 000
Prepaid taxes 500

Current liabilities 15,000

Quick ratio= 10, 000 + 5,000 +
1,000/ 15,000=1.07

Tea’s quick ratio of 1.07 means that the store

can pay off all of the current liabilities with
quick assets and still have some quick assets
left over.
4. Accounts Receivable Turnover Ratio-
accounts receivable turnover ratio measures how
many times a business can turn its accounts
receivable into cash during a period. In other words,
the accounts receivable turnover ratio measures how
many times a business can collect its average
accounts receivable during the year.
FORMULA: Accounts Receivable Turnover = Net Credit
Sales/ Average Accounts Receivable
Example:
2017 Net Sales 5,200,000
÷
Average Accounts Receivable 250,000
A/R turnover Ratio 20.80 times
2018 Net Sales 6,000,000
÷
Average Accounts Receivable 265,000
A/R turnover Ratio 22.64 times
Comparing the computed A/R Turnover
Ratios for the two periods, the company
has a higher ratio for 2018. This can be
attributed to a better performance from its
collection department.
5. Average Collection Period- the 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 compared with the previous A/R Turnover
Ratio. In fact, the A/R Turnover itself is a component
for the computation of the average collection period.
It 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. For
our illustrative examples, we will use 365
days as a numerator.
As much as possible, the goal is to have a
shorter average collection period. This would
mean the company is efficient in collecting their
outstanding Accounts Receivable from their
customers. A shorter average collection period
means that the company has more immediate
cash that can be used in its operation.
FORMULA: 365 days /A/R Turnover Ratio
Example:
2017 365
÷
A/R Turnover Ratio 20.80 times
Average Collection Period 17.54 days
2018 365
÷
A/R Turnover Ratio 22.64
Average Collection Period 16.12 days
The shorter average collection period in
2018 shows that the collection increased
its efforts to collect company receivables
as they fall due.
6. 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. A high turnover ratio shows
how efficient the company is in selling its inventory
to customers.

FORMULA: COGS / Average Inventory

Example:
2017 COGS 1,200,000
÷
Average Inventory 370,000
Inventory Turnover Ratio 3.24 times

2018 COGS 1,500,000

÷
Average Inventory 395,000
Inventory Turnover Ratio 3.79times
It can be seen in our computation that the
inventory turnover increased in 2018. It
means that the sales department sold
more products to customers in 2018.
7. Average Days in Inventory- this ratio states that the
number of days that it would take before an inventory
would be entirely sold by the company. This follows the
same concept in computing the average collection period.
The company uses 360 or 365 as the numerator and the
inventory turnover ratio as denominator. The goal is to
have shorter average days in inventory. A shorter amount
would mean that the cash of the company is not being tied
up to its inventory for a very long period of time.

FORMULA: 360 or 365 / Inventory Turnover Ratio

Example:
2017 365
÷
Inventory Turnover Ratio 3.24
Average day in Inventory 112.65 days

2018 365
÷
Inventory Turnover Ratio 3.79
Average Day in Inventory 96.30 days
The average days in inventory of this
company improved in 2018. This is
because the inventory turnover in 2018
also improved.
8. Number of Days in Operating Cycle-These are
the measures 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. The goal is to always
have a shorter number of operating cycles. A shorter
number would indicate that the company would have
additional cash at an earlier time.

FORMULA: Number of Days in Operating Cycle=

Example:
2017 Collecting Period 17.54 days
+
Average age of Inventory 112.65 days
Number of Days in OC 130.19 days

2018 Collecting Period 16.12 days

+
Average age of Inventory 96.30 days
Number of Days in OC 112. 42 days
A comparison between the two periods shows
an improvement of at least 17 days in the
operating cycle. It means that the company
improved as a whole when it comes to selling
their products and collecting their receivables.
The following are commonly used financial leverage
ratios will be highlighted:
1. Debt To Total Assets Ratio- is a solvency ratio
that measures a firm’s total liabilities as a
percentage of its total assets. In a sense, the debt
ratio shows a company’s ability to pay off its
liabilities with its assets. This shows how many
assets the company must sell to pay off all of its
liabilities.
The debt ratio is computed as follows:

Debt ratio = Total liabilities / Total assets

Example: Gino’s Guitar Shop is thinking about
building an addition at the back of its existing
building for more storage. Gino consults with the
banker about applying for a new loan. The bank
asks for Gino’s statement of financial position to
examine the overall debt levels. The banker
discovers that Gino has total assets of 100,000 and
total liabilities of 25,000. Gino’s debt ratio
would:
.25 = 25,000/ 100,000
Gino’s debt ratio of .25 is often considered less risky.
This means that the company has 4 times as many
assets as liabilities. Or said in a different way, this
company’s liabilities are only 25 percent of its total
assets. Essentially, only its creditors own ¼ of the
company’s assets and the owners own the
remainder of the assets.
2. Debt to Equity Ratio. The debt-to-equity
ratio is a financial, liquidity ratio that compares a
company’s total debt to total equity. The debt-to-
equity ratio shows the percentage of company
financing that comes from creditors and investors.
A higher debt to equity ratio indicates that more
creditor financing (bank loans) is used than
investor financing (shareholders)
FORMULA: Debt to Equity Ratio = Total
Liabilities / Total Equity
Illustration Assume a company has 100,000 of
bank lines of credit and a 500,000 mortgage on
its property. The owners of the company have
invested 1.2 million. The debt-to-equity ratio
will be as follows.
.50 = 100,000 + 500,000 / 1,200,000

A debt ratio of .5 means that there are

half as many liabilities as there is equity.
3. Times Interest Earned Ratio- time
interest earned is a tool that measures the
debt paying ability of the company. 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 a higher ratio of times interest earned.
Consider the table below indicating the operating
income and interest expense of Charm’s Company
for 2014 and 2015.
2015 2014
Operating income 600,000 460,000

Interest Expense 100,000 100,000

The times interest earned of Charm
Company is computed as follows:
2015 (600,000/100,000) = 6.0 times
2014 (460,000/100,000) = 4.6 times
The ratio may indicate that Charm can
cover interest payment from its operating
income 6 times in 2015 against 4.6 times
in 2014. The improvement in the measure
gave better protection to the creditors.
PROFITABILITY RATIOS
Profitability, as its name suggests, is a measure of
profit which business is generating. Profitability ratios are
basically a financial tool which helps us to measure the
ability of a business to create earnings, given the level of
expenses they are incurring. These ratios take into account
various elements of the Income statement and balance
sheet to analyze how the business has performed. Higher
the value of these ratios as compared to competition and
market, better the business’s performance.
TYPES OF PROFITABILITY RATIOS
1. 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 net sales of the company and cost of
goods sold.
As much as possible, the company wants to have a big
gross profit ratio. It means that it was able to generate more
sales from its cost of goods sold.
FORMULA: Gross Profit Ratio = Gross Profit / Net Sales
Example:
2017
Gross Profit 4,000,000
÷
Net Sales 5,200,000
Gross Profit ratio 76.92%
2018
Gross Profit 4,500,000
÷
Net Sales 6,000,000
Gross Profit ratio 75%
The company’s gross profit ratio slightly
decreased in 2018. This should be avoided or
at least be minimized. The gross profit ratio can
be improved by continuously finding inventories
with lower cost, without sacrificing quality.
2. Profit Margin Ratios
These ratios compare various profits of the business (gross
profit, operating profit, net profit, etc.) with its sales. 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 a more precise measure of the company’s
profitability because it has already considered the operating
expenses and other expenses of the entity. Like the gross profit
ratio, companies would want to have a high profit margin ratio. This
ratio can be computed by dividing the company’s NIAT with the
company’s net sales.
FORMULA: PROFIT MARGIN RATIO= NIAT/Net SALES
2017
Net Income After Tax 1,750,000
÷
Net Sales 5,200,000
Profit Margin Ratio 33.65%

2018
Net Income After Tax 1,400,000
÷
Net Sales 6,000,000
Profit Margin Ratio 23.33%
Comparing the ratios for the two periods, there
is an obvious decline in the company’s profit
margin ratio in 2018. This can be attributed to
the lower NIAT coupled by an increase in net
sales.
3. Operating Expenses to Sales Ratio
Operating expenses are the biggest expenses of
every company. It can be further classified into
General and Administrative Expenses and Selling
Expenses. These expenses are needed to generate
sales.
FORMULA: Operating Expenses to Sale Ratio
=
Operating Expenses / Net Sales
Example:
2017 Operating Expenses 1,000,000
÷
Net Sales 5,200,000
OE to Sale Ratio 19.23%

2018 Operating Expenses 500,000

÷
Net Sales 6,000,000
OE to Sale Ratio 8.33%
Comparing the data for the two years involved
shows that there is a huge improvement in the
operating expenses to sales ratio. This can be
attributed to lower operating expenses and
increase in net sales.
4. Return on Investment Ratio
The return-on-investment ratio has two
variations: Return on Asset and Return on
Shareholder’s Equity. They only differ on the
denominator, which would be used in the
computation.
a. Return on Assets
Before profits can be realized, certain
investments should be made. In this case, assets will
be used for the different projects of the company.
The goal is to generate profit based on the available
assets during the year. Thus, the company aims for
a higher return on assets.
FORMULA: Return on Assets = Profit /
Average total Assets
Example:
2017 Profit 1,750,000
÷
Average Total Assets 2,000,000
Return on Assets .875
2018 Profit 1,400,000
÷
Average Total Assets 2,200,000
Return on Assets .6363
There was a decline in the return on assets of
the company. This is something negative. This
can be attributed to a lower profit and higher
average total assets. It means that it is taking
more assets that are used to generate the
same number of profits for the company.
b. 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 one coming from stockholders alone. In the
return on assets the average total assets being used may
come predominantly from creditors. Overall, a company
should have a higher return on equity.
FORMULA: Return on Equity = Profit/ Average SHE
Example:
2017 Profit 1,750,000
÷
Average SHE 500,000
Return on equity 3 .5
2018 Profit 1,400,000
÷
Average SHE 575,000
Return on equity 2.43
In 2018, the return on equity decreased.
This could be attributed to a lower net
income after tax and a larger return on
equity in 2018.
5. Asset Turnover Ratio
This ratio measures the correlation
between the assets owned by the company
and the net sales generated by such
properties.
FORMULA: Asset Turnover Ratio =
Net Sales / Average Total Assets
Example:
2017 Net Sales 5,200,000
÷
Average Total assets 2,000,000
Assets Turnover Ratio 2.6
2018 Net Sales 6,000,000
÷
Average Total assets 2,200,000
Assets Turnover Ratio 2.72
The Asset turnover ratio slightly increased
in 2018. This is something positive. This
can be attributed to bigger net sales
generated for in 2018.
ACTIVITY 1: CHECK ME WHERE I BELONG!
DIRECTION: Put a check (/) in its respective column where the ratio belongs.
ACTIVITY 2
Direction: From the given table below, match column A to column B then
write your answer by putting the number in the space provided found in the
first column.
Activity 3:
Direction: Put a check (/) in its respective column where the ratio belongs.