Senior High School

Fundamentals of Accountancy,
Business and Management 2
Module 7: Computation and
Interpretation of Financial Ratios

LU_FABM 2_Module7
 Target

Financial ratios are deeper or more ingenious interpretation of financial

statements (FS). Statement of Financial Position (SFP) provides the company’s total
assets, liabilities and Owner’s Equity, Statement of Comprehensive Income (SCI) tells
if the business gained net income or incurred net loss, the Statement of Changes in
Equity (COE) shows how much the owner invested and can claim, and Cash Flow
Statements (CFS) traces the inflows and outflows of cash transactions of an entity.
But not all questions and queries of stakeholders can be readily answered by just
looking at the foot totals of financial statements. Amounts from FS are derived to
come up with information so that further questions and queries of entity’s
stakeholders which are essential in their decision making will be answered.

In your previous lesson, you are done defining the measurement levels,
namely liquidity, solvency, and profitability. You also performed vertical and
horizontal analyses of financial statements of a single proprietorship.

This module will provide you the formula, sample computations, and activities
that will enable you to compute and interpret financial ratios.

After going through this module, you are expected to:

Learning Competency
1. Compute and interpret financial ratios such as current ratio, working
capital, gross profit ratio, net profit ratio, receivable turnover, inventory
turnover, debt-t0-equity ratio, and the like. (ABM_FABM12-Ig-h-14)

Subtasks:
1. List the different financial ratios.
2. Identify the appropriate formula for certain financial ratio.
3. Compute and interpret the different financial ratios.

Before going on, check how much you remember about your previous lessons
that is very much connected with our topic. Answer the short review-test on
the next page in a separate sheet of paper.

LU_FABM 2_Module7
 Discover

The above activity shows that NOT all information needed by owners or the CEO
are readily available on the face of FS. This lesson will allow you to derive
meaningful information from the FS than just the amounts reported on it.

DIREFERENT FINANCIAL RATIOS

Financial ratios in accounting can be classified into three groups. Defined
and discussed in the previous modules, these three main groups have different ratios
under them. The different financial ratios with their corresponding formula are
tabulated and shown below:

LU_FABM 2_Module7
 Explore

The FS for 2018 and 2019 of THE LOG Company will be used as illustration.

LU_FABM 2_Module7
LIQUIDITY RATIOS
Liquidity is the capacity of a 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 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.
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 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. Using the data given for THE LOG Company, we can compute for the
working capital amounts of the period 2018-2019. Below is an example:

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 LOG Company is in a better liquidity position (working capital wise) in 2019 than
in 2018.

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. For
example, a current ratio of three would mean that the company has P3 worth of
current asset for every P1 of current liabilities. It means that there would be
P2 left after the payment of currently maturing obligations. Below is an example:

LU_FABM 2_Module7
 The company has whole number current ratios for the two periods. This is
positive. But comparing the 2 periods together, the company has a better current ratio
in 2018 than in 2019.

Acid Test Ratio

Acid Test Ratio is a stricter 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.
Below is an example:

It should be noted that the company has positive acid test ratios for 2018 and
2019. It means that the company has the capability to pay its currently maturing
obligations through its quick assets. Comparing both years, the analysis reveals that
the company was better off in 2018 than in 2019, acid test ratio wise.

C. Accounts Receivable Turnover Ratio

This ratio measures the frequency of conversion of the company’s Accounts
Receivable (A/R) to Cash. It measures how many times the company was able to
collect its Account Receivable from its customers. For the numerator, the company
should make use of total Net Credit Sales. But this data is not usually present in the
financial statements of most companies. As an alternative, the company could make
use of Total Net Sales. For the denominator, the average Accounts Receivable can be
computed by adding the beginning and ending balance of the Accounts Receivable
and dividing it by to. In cases where the beginning balance of the Accounts Receivable
is not present, especially if it is the first year of operations, the company can make
use of the ending balance of Accounts Receivable. As much as possible, the goal of
every company is to have a higher A/R Turnover Ratio.

LU_FABM 2_Module7
 Comparing the computed A/R Turnover Ratios for the two periods, the company
has a higher ratio for 2019. This can be attributed to a better performance from its
collection department.

D. 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 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. 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 examples, we are going to make use of 365 days. As much as
possible, the goal is to have a shorter average collection period. This will mean that
the company is efficient in collecting their outstanding Accounts Receivable from
their customers. A shorter average collection period will mean that the company will
have more immediate cash that can be used in their operations.
Example:

By showing a shorter average collection period for 2019, it would mean that the
collection department has increased in efforts to collect the company’s receivables as
they fall due. The conclusion for the A/R Turnover Ratio would be the same for the
average collection period.
The reason is that the A/R Turnover Ratio is a component of the formula for the
average collection period. It can be seen in our computation that the company has better
A/R Turnover Ration and Average Collection Period in 2019 than in 2015.

E. 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 13 high inventory turnover ratio. This will 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 the obsolescence of inventory. This will also tie up the company’s
cash resources to its inventory. This scenario is not favorable for a company’s
liquidity situation.

10

LU_FABM 2_Module7
 The numerator for this formula would be the company’s Cost of Goods Sold
(COGS). The computation of the average inventory would follow the same concept of
computing the average receivable in the earlier ratio. Below is an example:

The inventory turnover increased in 2019 which means, the sales department
sold more products to customers in 2019.

F. Average Days in Inventory

This ratio computes the number of days that it will take before a group of
inventories will be entirely sold by the company. This follows the same concept in
computing the average collection period. The company can make use of 360 or 365
as their numerator and will make use of the Inventory Turnover Ratio for its
denominator. The goal is to have shorter average days in inventory. A shorter number
will mean that the cash of the company is not being tied to its inventory for a very
long period. Below is an example:

The average days in inventory of this company improved in 2019. The reason is that
the inventory turnover ratio for 2019 also improved. G. Number of Days in Operating Cycle (OC
G. Number of Days in Operating Cycle (OC)
This is the measure on how long 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. Below is an example.

11

LU_FABM 2_Module7
 A comparison between the two periods will show that there was an improvement of
at least 18 days in the company’s operating cycle. It means that the company improved
when it comes to selling their products and collecting their receivables.

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 & bonds payable
will be interested in knowing its solvency status. There are three kinds of this ratio.

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. Example is given below:

Comparing 2018 & 22019 there is a slight decrease in the debt ratio of the
company. It means that the company was more solvent in 2019 than in 2018.

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. To get the debt to equity ratio, total liabilities will
be divided by its total shareholder’s equity or owner’s equity. Example is given below.

Comparing the debt to equity ratio of the company for the two periods concerned will
mean that the company was more solvent in 2019 than it was in 2018.

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

12

LU_FABM 2_Module7
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 times that 15
the loan or borrowing is not yet paid. As much as possible, companies would want
to have a high Times Interest Earned Ratio. A small or a decimal number ratio will
indicate that it is not worthy to borrow money from others if the company would not
be able to generate enough income to cover for it. Example is given below:

The times interest earned decreased in 2016. From “6”, it went down to “2”.
This is something negative when it comes to the solvency of the company. Although the
company’s EBIT increase in 2019, there was an even bigger jump in the interest
expense for the year.

PROFITABILITY RATIOS
One of the primary reasons why stockholders invest in 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 off 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 net sales of the company
and its 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.

To compute for the gross profit ratio, the gross profit is just divided by the net
sales of the company. To get the net sales of the company, the sales return and
allowances and the sales discount are both deducted from gross sales.

13

LU_FABM 2_Module7
 There was a slight decrease in the gross profit ratio of the company in 2019.
This is to be avoided or at least be minimized. The gross profit ratio can be improved
by continuously finding inventories with lower cost, without sacrificing its quality.

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 & other expenses of the entity.
Like the gross profit ratio, companies would want to have a high profit margin
ratio.
This ratio can be compound by dividing the company’s NIAT with the
company’s net sales.

Comparing the ratios for the two periods, there is an obvious decline in the
company’s profit margin ratio in 2019. This can be attributed to the lower NIAT coupled
by an increase in net sales.

C. Operating Expenses to Sales 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 expense by the total net sales.
This ratio should be minimized as much as possible. The goal is to generate
as many sales as possible with the minimum possible operating expenses.

14

LU_FABM 2_Module7
Comparing the data for the two periods, it can be seen that there was a huge
improvement in the operating expenses to sales ratio.

This can be attributed to lower operating expense and the increase in net sales.

D. Return on Investment
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.

i. 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.
Average total assets can easily be computed by adding the starting and ending
balance of assets and dividing it by two.

It can be seen that there was a decline in the return on assets of the company.
This is something negative

This can be attributed to a lover profit and higher average total assets. It means
that is taking more assets are used to generate the same amount of profits for the
company.

15

LU_FABM 2_Module7
ii. 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.

It can be seen that there is a decline in the return on equity for the second year.
This is something negative and can be attributed to a lower net income after tax for the
second year and a larger return on equity.

E. Asset Turnover Ratio

This ratio measures the correlation between the assets owned by the company
& the net 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.

Like other profitability ratios, the goal is to have a higher asset turnover ratio.

There is a slight increase in the asset turnover ratio. This is something positive.
This can be attributed to a bigger net sale generated for the second year.

16

LU_FABM 2_Module7
 Deepen

Exercise 1
Comprehensive Problem:

TLC Company was established on January 1, 2015 and is engaged in the

manufacture of farm tools. The company makes use of 365 days in its computation
for some of the ratios. You will find below their comparative SFP & SCI for two years.

17

LU_FABM 2_Module7
Direction: Compute the ratios listed below for 2016 and tell if it is good or bad.
Show solution.
1. Working Capital 13. Profit Margin Ratio

2. Current Ratio 14. Return on Assets

3. Quick/Acid Test Ratio 15. Return on Equity

4. A/R Turnover Ratio 16. Asset Turnover Ratio

5. Average Collection Period

6. Inventory Turnover Ratio

7. Average Days in Inventory
8. Number of Days in OC

9. Debt to Total Assets Ratio

10. Debt to Equity Ratio

11. Times Interest Earned Ratio

12. Gross Profit Ratio

18

LU_FABM 2_Module7