Fundamentals of Accounting Theory and Practice Part2

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Financial Statements and the Ratio Analysis

Module 010 Financial Statements and the Ratio

Analysis

Our last module in the course is about understanding more of the use of
financial statements and applying the ratio analysis. The analysis partly
discussed in this module pertains to ratio analysis to evaluate liquidity,
profitability, long-term solvency, and market ratios.
At the end of this module, you will be able to:
1. Define ratio analysis and its importance.
2. Identify the kinds of financial ratios and determine their importance.
3. Compute the standard financial ratios and use them in decision making
purposes.

Introduction to Ratio Analysis

Definition
Ratio is an expression of one number in terms of the other. It is a quantitative relation of
two amounts or numbers showing the number of times a value has or is restricted by the
other. It can be written or presented using the “:” symbol, as a single number, as a fraction,
or as a percentage.
Ratio Analysis is the quantitative evaluation of the much information listed in the firm’s
financial statements. It is considered as the foundation of fundamental financial analysis.

Importance of Ratio Analysis

Among the many importance of financial ratio analysis is:

1. It is used in evaluating the different facets of an entity’s financial performance and
operations.
2. It aids in identifying trends and comparisons between two or more business entities.
3. It helps in analyzing the possible underlying relationships among various line items in
the financial statement.
4. It can also be considered a way to evaluate management performance vis- a- vis the use
of company resources.
5. The results of the financial ratio analysis help in decision making like preparing budgets
and estimates, and formulating policies.

Some of the importance of ratio analysis will be detailed as we proceed with the
calculations of ratios.

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Financial Statements and the Ratio Analysis

Categories of Financial Ratios

The different categories of ratios that we will study are: liquidity ratios, profitability
ratios, long-term solvency ratios, and market ratios.
Liquidity Ratios – are the ratios that measure the firm’s ability to pay its current
obligations. These ratios explain the financial position of the business. It includes
the following ratios:
1. Current ratio
2. Quick ratio or acid-test ratio
3. Working capital ratio
4. Receivable turnover
5. Inventory turnover

Profitability Ratios – are ratios that measure the ability of a business entity to earn
profit for its investors and communicate financial performance of the business.
These include the following:
1. Net profit margin
2. Gross profit margin
3. Operating profit margin
4. Rate of Return on total assets
5. Rate of Return on owner’s equity
6. Earnings per share

Solvency Ratios – are ratios that assess the long-term financial sustainability of a
business like its ability to pay its long-term debts. These ratios include
1. Debt ratio
2. Debt to equity ratio
3. Times interest-earned ratio

Market value ratios – are ratios that evaluate the economic status of publicly-traded
company in the wider marketplace like the stock market. These ratios will help
prospective investors and the company itself if their shares of stock are overvalued
or undervalued or fairly priced. The most common ratios are
1. Price/earnings ratio
2. Dividend yield
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Financial Statements and the Ratio Analysis

Calculations of Liquidity Ratios

To best illustrate our calculations, we will be using comparative income statement
and comparative balance sheet. We will be computing for 2016 ratios.
SMR Department Store
Comparative Income Statement
For the Years Ended December 31, 2015 and 2016
2016 2015
Net sales ₱ 670,000 ₱ 600,000
Cost o goods sold 350,000 285,000
Gross profit ₱ 320,000 ₱ 315,000
Operating expenses
Selling ₱ 100,000 ₱ 90,000
Administrative 50,000 30,000
Total operating expenses ₱ 150,000 ₱ 120,000
Income from operations ₱ 170,000 ₱ 195,000
Interest revenue 20,000 15,000
Interest expense (25,000) (20,000)
Income before income tax ₱ 165,000 ₱ 190,000
Income Tax 52,800 60,800
Net income for the period ₱ 112,200 ₱ 129,200

SMR Department Store

Comparative Statement of Financial Position
December 31, 2015 and 2016
Assets
2016 2015
Current Assets
Cash ₱ 49,000 ₱ 55,000
Account Receivables, net 134,000 85,000
Inventories 133,000 130,000
Prepaid Expenses 26,000 30,000
Total current assets ₱ 342,000 ₱ 300,000
Plant Assets, net 528,000 420,000
Total Assets ₱ 870,000 ₱ 720,000
Liabilties and Shareholders' equity
Current liabilities
Accounts Payable ₱ 95,000 ₱ 80,000
Notes Payable 60,000 45,000
Accrued liabilities 47,000 51,000
Total current liabilities ₱ 202,000 ₱ 176,000
Long-term liabilities 309,000 218,000
Total liabilities ₱ 511,000 ₱ 394,000
Shareholder's equity
Ordinary Shares, no par ₱ 219,000 ₱ 219,000
Retained earnings 140,000 107,000
Total shareholders' equity ₱ 359,000 ₱ 326,000
Total liabilities and shareholders' equity ₱ 870,000 ₱ 720,000

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Financial Statements and the Ratio Analysis

A. Measuring the ability to pay current liabilities

1. Working Capital (WC) - Working capital is the difference between the total
current assets and total current liabilities.
The working capital of SMR for 2016 is P42, 000.
WC = Total current assets - total current liabilities
P342, 000 – P202, 000 = P140, 000

This means that the company has the ability to pay its short-term liabilities.
The excess can be used for day to day operations. If the WC is too big enough,
this might mean that some of the firm’s assets are not being invested the
long-term and they are not utilized well to help the company grow.

2. Current ratio (CR) – Cr is the most commonly used liquidity ratio. It is the
calculated by dividing total current assets by total current liabilities.
Current Ratio = Total current assets / Total current liabilities
The current ratio of SMR for 2016 is 1.14: 1 or 1.14.
CR = P342, 000 / P202, 000 = 1.14
This also shows that the company has the ability to pay its current debts. The
higher (than 1) the CR the better for the company. The CR is also called the
WC ratio.
3. Acid-test ratio or quick ratio (QR) – This ratio will tell us that the firm could
pay all its current obligations if they became due immediately, this is the acid
test. Quick assets consist of cash, short-term investments as marketable
securities, if any, and accounts and notes receivable, net of allowance for
uncollectible. We will not include inventory and prepaid expenses because
these are not subject to immediate collections to pay current liabilities.
The acid- test ratio of SMR is .61.
Calculated as follows:
QR = (Cash P49, 000 + Accounts Receivable P134, 000) / Current liabilities
P300, 000 = .61
The customary rule of thumb for quick ratio is 1:1. If it is below 1, will entail
an analysis of receivables on how frequent the firm collected them and the
credit and collection policy.
B. Measuring the ability to sell merchandise and collect receivables
1. Inventory turnover (ITO) – measures the number of times a company sells its
average inventory during a given accounting period. The higher the rate of
turnover, the better for the business.
This is calculated by dividing cost of goods sold by the average inventory.
Average inventory is the sum of the inventories for two consecutive years
divided by 2.
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Financial Statements and the Ratio Analysis

The inventory turnover for SMR is

Calculated as follows:
ITO = cost of goods sold / average inventory
P350, 000 / [(P133, 000 + P130, 000)]/2 = 2.66 times
The higher the ITO the better for the firm. Determining the best ITO depends
on the nature of business and the average in the industry it operates.

2. Day's sales on hand or Days in inventory (DSI). This refers to the number of
day’s sales being carried in inventory. This is a variation of inventory
turnover. It is calculated by dividing 360 days (we assume there are 360 days
in a year for ease in computation) by the inventory turnover ratio.

The days in inventory for SMR are 135.33 days.

This is calculated as follows:
Days in inventory = 360 days / 2.66 = 135.33 days.
3. Accounts Receivable turnover (ARTO) – determines the ability of the business
to collect cash from customers. It calculates the number of times in an
operating cycle, usually a year, to collect its receivables.
It is computed by dividing net credit sales by the average receivables. Net
credit sales refer to sales on credit or on account less the sales returns and
allowances and sales discounts, the firm has granted to credit customers.

The ARTO for SMS in 2016 assuming that the total sales are on credit is 6.11.
Computed as follows:
ARTO = Net sales P670, 000 / [(P134, 000 + P85, 000)]/2 = 6.11 times
4. Day’s Sales in Receivables (DSR) - is the ratio of average net accounts
receivables to one day of sales. This can simply mean the number of days
within which the receivable will be collected.
This calculated by dividing 360 days by the ARTO. The DSR for SMR is 58.92
days.
DSR = 360 days / 58.92 = 58.92 days.
Calculations of Profitability Ratios
The main objective of any business organization is profit. Hence, it is very important
to measure profitability as it plays a very important role in decision making.
1. Net profit margin (NPM)– also called the rate of return on net sales or return
on sales, is the ratio of net profit to total net sales
The net profit margin for SMR is 16.75%, computed as follows:
Net profit / net sales
P112, 200 / P670, 000 = 16.75%

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2. Gross profit margin (GPM) - is the ratio of gross profit to net sales.
The gross profit margin of SMR is 47.76% computed as follows:
Gross profit / net sales
P320, 000/ P670, 000 = 47.76%

3. Operating profit margin (OPM) – is the ratio of income from operations to net
sales.
For SMR, the operating margin ratio is 25.37%, computed as
Operating income /net sales
P170, 000 / P670, 000 = 25.37%

4. Rate of return on total assets or return on assets (ROA) – is the ratio that
measures the ability of the firm to use its assets to generate profit.
The ROA is computed by dividing the sum of the net income and interest
expense by the average total assets.

The ROA for SMR is 17.26%, computed as follows:

(Net income + interest expense) / average total assets
(P 112,200 + P25, 000)/ [(P870, 000 + P720, 000)]/2 = 17.26%

If we do not add back the interest expense the ROA is 14.11%

Others do not add back the interest expense. We just add back the interest
expense as we consider the net income of the two groups –creditors and
shareholders) who financed the business.

5. Rate of Return on Owners’ (or Shareholders’) Equity. This is also called

return on ordinary equity or return on equity (ROE). This ratio shows the
relationship between net income and the ordinary shareholders investment
in the firm.

This is computed by dividing net income less preference shares dividends by

the average ordinary shareholders’ equity.

SMR.s ROE is 32.76%, calculated as follows:

ROE = Net income / average ordinary shareholders’ equity
= P112, 200 / [(P359, 000 + P326, 000)]/2 = 32.76%

6. Earnings per share of Ordinary Shares (EPS) – is the amount of the firm’s
income earned for every outstanding ordinary share. This is calculated by
dividing net income available to ordinary shareholders by the number of
outstanding ordinary shares during the period.
SMR has no preferred shares so all shares are considered ordinary. Its shares
have no par value, so we assumed a stated value of P10 per share.
The EPS for SMR is P5.12 per share, computed as follows:
EPS = Net income / no. of shares outstanding
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Financial Statements and the Ratio Analysis

P112, 200 / (P219, 000/P10) = P5.12 per share

Calculations of Solvency Ratios

Solvency ratios or Long-term solvency ratios evaluate the financial viability of the
firm on a long –term basis. They show the ability of the firm to pay long-term debts.
1. Debt ratio shows us the ratio or proportion of the total assets financed by
debts. This is calculated by total liabilities by total assets.

For SMR, the debt ratio is 58.74%, computed as follows:

Debt ratio = total liabilities/ total assets
P511, 000 / P870, 000 = 58.74%
This means that more than half of the total assets are financed by debts.

2. Debt to equity ratio – measures the ratio or proportion of total liabilities to

the total equity. Calculated by dividing total liabilities by total equity.
SMR’s debt to equity ratio is 1.42 or 142%, calculated as follows;
Debt to equity ratio = total liabilities / total equity
P511, 000/ P359, 000 = 142%

3. Times interest-earned ratio –shows the ratio of net income from operations
to interest expense. This is also called the interest coverage ratio, as it
measures the number of times income from operations can cover the interest
expense. This is arrived at by dividing income from operations by interest
expense.
SMR’s time interest-earned ratio is 6.8, calculated as follows:
Times interest earned ratio = income from operations / interest expense
P 170,000 / P25, 000 = 6.8

If the income from operations is not given, we can estimate it by adding

interest expense to income before income tax.

Calculations of Market Value Ratios

1. Price/earnings ratio (PER) –is the ratio that relates the market price of an
ordinary share to the company’s earnings per share. It measures the value that
the stock market assigned on per peso of the company’s earnings.
This is calculated by dividing the market price per ordinary share by EPS.
Assuming the market price of SMR’s share is P 50, the PER are 9.76, computed as
follows:
PER = market price per ordinary share / EPS
P50 / P5.12 = 9.76
This means that the SMR share is selling at 9.76 times
earnings.

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Financial Statements and the Ratio Analysis

2. Dividend yield is the ratio of dividends per share of stock to the stock market
price. It measures the percentage of share’s market value that the company is
paying as dividends to shareholders.
This is calculated by dividing dividend per ordinary share by ordinary share
market price.
Assuming a dividend per share for SMR of P 3, the dividend yield is
Dividend yield = dividend per ordinary share / share market price
P 3 / P50 = P.06.

Glossary
Financial ratio analysis: is the evaluation of one line item in a financial statement in
relation to other line items.
Liquidity: the ability of a company to have sufficient current assets to be used in settling
current liabilities as they became due.
Profitability: the ability of the firm to generate profits.
Quick assets: the current assets of the firm that can be immediately be converted to cash.
Ratio: is the relation of one number, the numerator, in terms of the other, the
denominator.
Solvency: the ability of the firm to sustain the business and the ability to cope with long
term obligations to third parties.

References and Supplementary Materials

Books and Journals
Ballada, W. & Ballada, S. (2015). Partnership and Corporation Made Easy (19th
ed.).Sampaloc, Manila. Dom Dane Publishing.

Cabrera, ME. C. (2008). Fundamentals of Accounting Vol. 2. Manila,Philippines: GIC

Eneterprises & Co., Inc.

Horngren, C.T., Harrison,Jr., W. T., Bamber, L.S. (2002) Accounting (5 th Edition). USA:
Prentice Hall International, INc.

Passion, D.S., Pasion, W. T., Pasion, E.T.(1998). Introductory Accounting Volume 2.

Manila,Philippines: Phoenix Publishing House, Inc.

Palma, R.Z. (2014). Basic Accounting 2: Partnership and Corporation. Quezon City,
Philippines: Rex Bookstore, Inc.
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Online Supplementary Reading Materials

[PDF]Financial Analysis Lecture Notes (FIN3403, P. Peterson)
educ.jmu.edu/~drakepp/FIN345/ratios.pdf
Accessed: July 31, 2017

[PDF]Financial Statement Analysis [FIN 510A] - Stevens Institute of ...

https://www.stevens.edu/sites/stevens_edu/.../FIN510A%20syllabus_Fall%202016.pdf
Accessed: July 31, 2017

Reading: Financial Ratio Analysis | Introduction to Business

courses.lumenlearning.com/.../chapter/financial-ratio-analysis
Accessed: July 31, 2017

Online Instructional Videos

Financial Statement Analysis - FIN621 - VU Video Lectures
www.vutube.edu.pk/vu-lectures/viewcategory/127/financial-statement-analysis-fin621
Accounts : Ratio Analysis : Lecture 1 - YouTube
Accessed: July 31, 2017

https://www.youtube.com/watch?v=-4V391EDnE4
May 25, 2016 - Uploaded by CA dilip badlani
Accessed: July 31, 2017

Intro to ratios (video) | Khan Academy

www.khanacademy.org/math/pre-algebra/pre-algebra-ratios..
Accessed: July 31, 2017

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