V.

FINANCIAL STATEMENTS ANALYSIS USING

RATIOS
LEARNING OBJECTIVES
1. Explain the financial ratios and their significance
used in analyzing the firm’s.
a. Liquidity or Short-term Solvency
b. Activity / Asset Management
c. Debt Management and Leverage
d. Operating Proficiency and Profitability
2. Apply the financial ratios in analyzing and
evaluating the firm’s financial position and
operating efficiency.
Financial Ratio Analysis
- is a comparison in fraction, proportion, decimal or
percentage of two significant figures taken from the
financial statements. It expresses the direct relationship
between two or more items in the statement of financial
position and statement of comprehensive income a
business firm.

Purpose
Through ratio analysis, the financial statements user
comes into possession of measures which provide insight
into the profitability of operations, the soundness of the
firm’s short-term and long-term financial condition and
the efficiency with which management has utilized the
resources entrusted to it.
Limitations of Financial Ratios
Ratios have been found to be very useful
because there are in fact many related items in
the financial statements.
However, should be analyzed in the context of
the specific user and the limitation of the
financial statements.
1. Ratios must be used only as financial tools,
that is, as indicators of weakness or strength and
not to be regarded as good or bad per se.
2. Financial ratios are generally computed
directly from the company’s financial
statements, without adjustment.
3. Ratios are a composite of many different
figures – some covering a time period, others an
instant time and still others representing
averages.
4. Ratios to be meaningful should be evaluated
with the use of certain yardsticks. The most
common of these are:
a. Company’s own experience (prior years)
b. Other companies in the same industry
(industry averages)
c. standard set by management (a budget)
d. Rules of thumb
The financial ratios can be categorized as follows:
1. Liquidity / Solvency ratios – these ratios give us an idea of the
firm’s ability to pay off debts that are maturing within a year or
within the next operating cycle. Satisfactory liquidity ratios are
necessary if the firm is to continue operating.

Primary test of solvency

to meet current
obligations from current
1. Current ratio Total Current Assets
Total Current Liabilities assets as a going
concern, measure of
adequacy of working
capital

A more severe test of

2. Acid-test Total Quick Assets* immediate solvency; test
ratio or quick Total Current of ability to meet
ratio Liabilities demands from current
assets.
 Measures short-term
Cash + Marketable liquidity by considering
3. Cash Flow Securities + Cash Flow as cash resources
Liquidity Ratio
from Operating (numerator) cash plus
Activities cash equivalents plus
Current Liabilities cash flow form operating
activities.

Current Assets
4. Working less
Capital Current Liabilities
Indicates relative
liquidity of total
5. Working Working Capital assets and
Capital to total Total Assets distribution of
assets
resources employed.
I. Analysis of Liquidity or Short-Term Solvency Position
A. Current Ratio - is widely regarded as a measure of
short-term debt-paying ability. Current liabilities are
used as denominator because they are considered to
represent the most urgent debts requiring retirement
within one year or one operating cycle.
A declining ratio could indicate a deteriorating
financial condition or it might be the result of paring
of obsolete inventories or other stagnant current
assets.
An increasing ratio might be the result of an unwise
stock piling of inventory or it might indicate an
improving financial situation.
I. Analysis of Liquidity or Short-Term Solvency Position
A. Current Ratio - is widely regarded as a measure of
short-term debt-paying ability. Current liabilities are
used as denominator because they are considered to
represent the most urgent debts requiring retirement
within one year or one operating cycle.
A declining ratio could indicate a deteriorating
financial condition or it might be the result of paring
of obsolete inventories or other stagnant current
assets.
An increasing ratio might be the result of an unwise
stock piling of inventory or it might indicate an
improving financial situation.
 The current ratio is useful but tricky to interpret and
therefore, the analyst must look closely at the
individual assets and liabilities involved.
Some analyst eliminate prepaid expenses from the
numerator because they are not potential sources of
cash but, rather, represent future obligations that have
already been satisfied.

B. Quick or Acid test ratio – is a much more rigorous test

of a company’s ability to meet its short-term debts.
Inventories and prepaid expenses are excluded from
total current assets leaving only the more liquid assets
to be divided by current liabilities.
 This is designed to measure how well a company
can meet its obligations without having to
liquidate or depend too heavily on its inventory.
Since inventory is not an immediate source of
cash and may not even be saleable in times of
economic stress, it is generally felt that to be
properly protected; each peso of liabilities
should be backed by at least P1 of quick assets.
C. Cash-Flow Liquidity Ratio – considers cash flow
from operating activities (from the statements of
cash flows) in addition to the truly liquid assets
cash and marketable securities.
2. Activity / Asset management ratios – these ratios give us an idea
of how efficiently the firm is using its assets. Good asset
management ratios are necessary for the firm to keep its costs
low and thus, its net income high.
1. a) Trade Net credit sales * Velocity of collection of
receivable Average Trade trade accounts and
turnover Receivable (net) notes; test of efficiency
of collection.
b) Average
360 days
Collection Receivable Turnover
period Evaluates the liquidity of
accounts receivable and
c.) number of the effectiveness of the
days’ sales Accounts Receivable firm’s credit policies.
uncollected Net Sales / 360
2. Inventory Cost of goods sold Measures efficiency
Turnover Average Merchandise of the firm in
a) Merchandise Inventory managing and selling
Inventory turnover inventories.

b) Days supply in 360 Measures average

inventory / Average Inventory Turnover number of days to
sale period sell or consume the
average inventory

Net Sales Measures efficiency

3. Assets / Average Total Assets of the firm in
Investment or Assets or managing all assets
Turnover Total Investment to generate revenue.
II. Analysis of Activity / Asset Management Efficiency
A. Accounts Receivable Turnover – roughly measures
how many times a company’s accounts receivable have
been turned into cash during the year.
B. Average Collection Period – helps evaluate the
liquidity of accounts receivable the firm’s credit
policies. The long collection period may be a result of
the presence of many old accounts of doubtful
collectability, or it may be the result of poor day-to-day
credit management such as inadequate checks on
customers or perhaps no follow-ups are being made on
slow accounts. There could be other explanations such
as temporary problem caused by a depressed
economy.
C. Inventory Turnover – measures the efficiency of the
firm in managing and selling inventory. It is computed
by dividing the cost of goods sold by the average level of
inventory on hand. The ratio is sometimes computed
with net sales as the numerator and the average level of
inventory as denominator.
Generally a high turnover is preferred because it is a sign
of efficient inventory management and profit for the
firm.
But high turnover could also mean underinvestment in
inventory and lost orders, a decrease in prices, a
shortage of materials or more sales than planned.
A low turnover could mean that the company is carrying
too much inventory or it has obsolete, slow-moving or
inferior inventory stock.
D. Average Sale Period / Days Supply in Inventory
- The number of days being taken to sell the entire
inventory one time (called the average sale or
conversion period) is computed by dividing 360 days by
the inventory turnover.
Generally, the faster inventory sells, the lesser funds are
tied up in inventory and more profits are generated.
E. Total Assets Turnover – is a measure of the
efficiency of management to generate sales and thus
earn more profit for the firm.
When the asset turnover ratios are to the industry or
the firm’s historical record, it could mean that either
the investment in asset is too heavy or sales are
sluggish.
3. Debt management and leverage ratios – these ratios
would tell us how the firm has financed its assets as
well as the firm’s ability to repay its long-term debt.
Debt management ratios indicate how risky the firm is
and how much of its operating income must be paid to
creditors rather than shareholder.
Shows proportion
Total Liabilities of all assets that
1. Debt Ratio Total Assets are financed with
debt.

Indicates proportion
of assets provided by
Total Owner’s Equity owners. Reflects
2. Equity ratio Total Assets financial strength and
caution to creditors.
 Measures debt
3. Debt to relative total
equity ratio Total Liabilities
Total Owners amounts of
Equity resources
provided by
owners

Income before Measures how

4. Times Interest Interest and many times
Earned Taxes interest expense
Annual Interest is covered by
Charges operating profit.
III. Analysis of Debt Management and Leverage
A. Debt Ratio – measures the proportion of all
assets that are financed with debt. Generally, the
higher the proportion of debt, the greater the risk
because creditors must be satisfied before owners
in the event of bankruptcy.
The use of debt involves risk because debt carries a
fixed obligation in the form of interest charges and
principal repayment. Failure to satisfy the fixed
charges associated with debt will ultimately result
in bankruptcy.
B. Debt to Equity Ratio – measures the riskiness of
the firm’s capital structure in terms of relationship
between the funds supplied by creditors (debt) and
investors (equity).
C. Times Interest Earned – is the most common
measure of the ability of a firms operations to
provide protection to long-term creditors. The
more times a company can cover its annual interest
expense from operating earnings, the better off will
be the firm’s investors.
4. Profitability ratios – these ratio give us an idea of
how profitable the firm is operating and utilizing its
assets. Profitability ratios combine the asset and
debt management categories and show their effects
on return on equity.
Measures profit
generated after
1. Gross profit Gross Profit consideration of
margin Net Sales cost of product
sold.

Measures profit
generated after
2. Operating Operating Profit consideration of
profit margin Net Sales operating costs.
3. Net profit Measures profit
margin Net Profit generated after
(Rate of return consideration of all
Net Sales expenses and
on net sales)
revenues.
Net Profit Measures overall
Average Total Assets efficiency of the firm
4. Rate of Return or in managing assets
on assets (ROA) * Asset Turnover and generating
Net Profit Margin profits.
5. Rate of return Measures rate of
on equity** Net Income return on
resources
Ave. SHE provided by
owners.
IV. Analysis Operating Efficiency and Profitability
A. Gross Profit Margin – shows the relationship
between sales and the cost of products sold, measures
the ability of a company both to control costs and
inventories or manufacturing of products and to pass
along price increases through sales to customers.
B. Operating Profit Margin – is a measure of overall
operating efficiency and incorporates all of the
expenses associated with ordinary or normal business
activities.
C. Net Profit Margin – measures profitability after
considering all revenue and expenses, including
interest, taxes and nonoperating items such as
extraordinary items, cumulative effect of accounting
change, etc.
D. Return on Investment on Assets (ROA)
E. Return on Equity (ROE) – ROA & ROE are two ratios
that measure the overall efficiency of the firm
managing its total investment in assets and in
generating return to shareholders. These ratios
indicate the amount of profit earned relative to the
level of investment in total assets and investment of
common shareholders.