FINANCIAL RATIO ANALYSIS

Illustrative Problem

The statements of Financial Position as of December 31, 2017 and 2018, Statement of Financial
Performance and Statements of Retained Earnings of ABC Enterprises, Inc. for years 2017 and
2018 are given below:

ABC Enterprises, Inc.

Statement of Financial Position at December 31, 2018 and 2017
(In thousands)

2018 2017
ASSETS
Current Assets
Cash Ρ 2,030.5 Ρ 1,191.0
Marketable Securities 2,636.0 4,002.0
Accounts Receivable 4,704.0 4,383.5
Allowance for doubtful accounts (224.0) (208.5)
Inventories 23,520.5 18,384.5
Prepaid expenses 256.0 379.5
Total Current Assets 32,923.0 28,132.0

Property, Plant and Equipment

Land 405.5 405.5
Buildings and leasehold improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
20,303.5 13,253.5
Less: accumulated depreciation and amortization (5,764.0) (3,765.0)
Net Property, plant and equipment 14,539.5 9,488.5

Other Assets 186.5 334.0

TOTAL ASSETS Ρ 47,649.0 Ρ 37,954.5

LIABILITIES AND EQUITY

Current Liabilities
Accounts payable Ρ 7,147.0 Ρ 3,795.5
Notes payable – banks 2,807.0 3,006.0
Current maturities of long term debt 942.0 758.0
Accrued Liabilities 2,834.5 2,656.5
Total current liabilities 13,730.5 10,216.0
Deferred Income Taxes 421.5 317.5

Long-term Debt 10,529.5 8,487.5

TOTAL LIABILITIES Ρ 24,681.5 Ρ 19,021.0

Equity
Ordinary shares,par value P1, authorized Ρ 2,401.5 Ρ 2,297.0
10,000,000 shares, issued 2,297,000 shares in
2017 and 2,401,500 shares in 2018
Additional Paid-In Capital 478.5 455.0
Retained Earnings 20,087.5 16,181.5
TOTAL EQUITY 22,967.5 18,933.5

TOTAL LIABILITIES & EQUITY Ρ 47,649.0 Ρ 37,954.5

 ABC Enterprises, Inc.
Statement of Financial Performance
For the Years Ended December 31, 2018 and 2017
(In thousands)

2018 2017
Net Sales Ρ 107,800.0 Ρ 76,500.0
Cost of Goods Sold 64,682.0 45,939.5
Gross Profit 43,18.0 30,560.5

Selling and administrative expenses 16,332.0 13,191.0

Advertising 7,129.0 5,396.0
Lease payments 6,529.0 3,555.5
Depreciation and amortization 1,999.0 1,492.0
Repairs and maintenance 1,507.5 1,023.0
Total Expenses 33,496.5 24,657.5

OPERATING PROFIT 9,621.5 5,903.0

Other income (expenses)

Interest Income 211.0 419.0
Interest Expense (1,292.5) (1,138.5)
Earnings before income taxes 8,540.0 5,183.5

Income taxes 3,843.0 2,228.5

NET INCOME Ρ 4,697.0 Ρ 2,955.0

ABC Enterprises, Inc.

Statement of Retained Earnings
For the Years Ended December 31, 2018 and 2017
(In thousands)
2018 2017
Retained earnings at beginning of year Ρ 16,181.5 Ρ 14,157.5
Net Income 4,697.0 2,955.0
Cash dividends (2018: P0.33 per share; (791.0) (931.0)
2017: P0.41 per share)
Retained Earnings at end of year Ρ 20,087.5 Ρ 16,181.5
Other Data:
Market Value Per Share P 30.00 P 17.00

Required:
Using financial ratios, evaluate the company’s financial position and operating results for the
year 2018 and 2017
SOLUTION WITH EXPLANATION:

2018 2017
1. LIQUIDITY
Current Ratio Current Assets ÷ 32,923.0 ÷ 13,703.5 28,132 ÷ 10,216
Current Liabilities
2.40 times 2.75 times
ABC’s current ratio indicates that at year-end 2018 current assets covered current liabilities
2.40 times down from 2013. Its significance could be best evaluated by comparing this with
industry competitors or the company’s trend liquidity over a longer period.
Quick or Acid Test Quick Assets ÷ 9,146.5 ÷ 13,703.5 9,368 ÷ 10,216
Ratio Current Liabilities
0.67 times 0.92 times
ABC’s quick ratio indicates deterioration between year 2017 and 2018. The acid-test ratio must
also be examined in relation to other firms in the same industry.
2. ASSET MANAGEMENT
Accounts Receivable Net Sales ÷ Ave. 107,800.0 ÷ 4,327.5 76,500.0 ÷ 4,175.0
Turnover Accounts Receivable
24.90 times 18.32 times
ABC Inc. converted accounts receivable into cash 24.9 times in 2018 than 18.32 times in 2017.
The turnover of receivable has improved and this may indicate better quality of receivable and
improvement of the firm’s collection and credit policies. Generally, a high turnover is good
because it could indicate efficiency in the collection of receivable, but a very high turnover may
not be favourable bcause it may indicate that credit and collection policies are overly restrictive.
Average Collection 365 days ÷ Accounts 365 ÷ 24.90 365 ÷ 18.32
Period Receivable Turnover
14.6 or 15 days 19.9 or 20 days
The ratios for ABC, Inc. indicate that during 2018, the firm collected its accounts in 15 days on
average, an improvement over the 20-day collection period in 2017. Whether the average of
15 days taken to collect an account is good or bad depends on the credit terms ABC is offering
its customers. If the credit terms are 10 days, then a 15-day average collection period would
be viewed as good. Most customers will tend to withhold payment for as long as the credit
terms will allow and may even go over a few days.
Inventory Turn-over Cost of Goods Sold ÷ 64,682.0 ÷ 20,952.5 45,939.5 ÷
Ave. Inventory 18,384.50
3.09 times 2.50 times
The inventor turnover of ABC, Inc. was 3.09 times in 2018, an improvement over 2017’s 2.50
times.
Generally, a high turnover is preferred because it is a sign of efficient inventory management
and profit for the firm. But a 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 relatively
low turnover could mean that the company is carrying too much inventory or it has obsolete,
slow-moving or inferior inventory in stock.
Average Sales Period 365 days ÷ Inventory 365 ÷ 3.09 365 ÷ 2.50
Turnover
118 days 146 days
ABC’ s average sale or conversion period decreased from 146 days in 2017 to 118 days in 2014.
This is evidence of efficiency in managing the inventories in 2018.
Fixed Asset Turnover Net Sales ÷ Average 107,800.0 ÷ 76,500.0 ÷ 9,4888.5
net PPE 12,014.0
8.97 times 8.06 times
The fixed asset turnover improved slightly because of the 41% (107800-76500/76500) increase
in sales as compared with 26% increase in average fixed assets.
Total Asset Turnover Net Sales ÷ Average 107,800 ÷ 42,801.75 76,500 ÷ 37,954.50
Total Assets
 2018 2017
2.52 times 2.02 times
The total asset turnover has improved primarily because of the improvement in fixed assets,
inventory and accounts receivable turnover.
When the asset TO ratios are low relative to the industry or the firm’s historical record, it could
mean that either the investment in assets is too heavy or sales are sluggish. There may
however be justification for the low turnover. For example, the firm may have undertaken an
extensive plant modernization or placed in assets its service at year-end which will generate
positive returns in the long-term.
3. SOLVENCY
Debt Ratio Total Liabilities ÷ 24,681.5 ÷ 47,649.0 19,021.0 ÷ 37,954.5
Total Assets
51.8% 50.1%
ABC’s debt ratio in 2018 and 2017 indicate relatively heavy reliance on borrowed capital and
they have reached the generally considered maximum ratio of 50% debt and 50% equity. Too
much debt would pose difficulty in obtaining additional debt financing when needed or that
credit is available only at extremely high rates of interest and most onerous terms.
Debt to Equity Ratio Total Liabilities ÷ 24,681.5 ÷ 22,967.5 19,021.0 ÷ 18,933.5
Total equity
107.46% 100.46%
The 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). ABC’s debt
to equity ratio has increased between 2018 and 2017, implying a slightly riskier capital
structure.
Times Interest Operating Profit ÷ 9,621.5 ÷ 1,292.5 5,903.0 ÷ 1,138.5
Earned Interest Expense
7.44 times 5.18 times
While ABC, Inc. increase its use of debt in 2018, the company improved its ability to cover
interest payment from operating profits.
Fixed charge Operating profit + 9,621.5 + 6,529 5,903.0 + 3,555.5
coverage Lease payment 1,292.5 + 6,529 1,138.5 + 3,555.5
Interest expense +
Lease payment
2.06 times 2 times
ABC Inc. experienced a significant increase in the amount of annual lease payment in 2018 but
was still able to improve its fixed charge coverage.

4. PROFITABILITY
Gross Profit Margin Gross Profit ÷ Net 43,118.0 ÷ 30,560.5 ÷ 76,500.0
Sales 107,800.0
40% 39.95%
ABC’s gross profit margin for both 2018 and 2017 have been stable which is considered positive
sign even if the company had to offer probably discounted items to attract customers or feature
“sale” to hasten up inventory turnover.
Operating Profit Operating Profit ÷ 9,621.5 ÷ 107,800 5,903 ÷ 76,500
Margin Net Sales
8.9% 7.7%
ABC’s operating profit margin improved from 7.7% to 8.9%. This is favourable because it
indicates ability of the company to control its operating expenses while sharply increasing sales.
Net Profit Margin Net Income ÷ Net 4,697 ÷ 107,800 2,955 ÷ 76,500
Sales
4.36 % 3.87%
ABC’s net profit margin slightly increased despite increased interest and tax expenses and a
reduction in interest revenue for marketable security investment.
Return on Assets Net Income + 4,697 + [127.5 (1- 2,955 + [1,138.5 (1-
[Interest (1 – Tax 45%)] ÷ 43,802
43%)] ÷ 39,955
Rate)] ÷
 2018 2017
Ave. Total Assets
10.88% 9.02%

Return on Equity Net Income ÷ Ave. 4,697 ÷ 20,950.50 2,955 ÷ 18,933.5

Stockholders’ Equity
22.42% 15.60%

MARKET VALUE
RATIOS
Basic Earnings per Net Income ÷ 4,697,000 ÷ 2,955,000 ÷
Share Weighted Ave. 2,349,250 2,297,000
Number of ordinary
shares outstanding
Ρ 2.00 Ρ 1.29
ABC’s EPS increased from 1.29 t0 2.00 in 2018 which is a clear indication in the improvement
on the investment return of ordinary shareholders.
Price Earnings (P/E) Market price of 30 ÷ 2 17 ÷ 1.29
Ratio ordinary shares ÷
Earnings per share
15 13.39
ABC’s price to earnings ratio is higher in 2018 than in 2017. This could be because the market
is reacting favourably to the firm’s good year.
Dividend Payout Dividends per share 0.33 ÷ 2 0.41 ÷ 1.29
Ratio ÷ Earnings per share
16.5% 31.78%
ABC reduced its cash dividend payment in 2018. It is particularly unusual for a firm to reduce
dividends during a good year. A possible explanation for this though may be the adoption of
new policy that will lower dividend payments in order to increase the availability of funds that
may be reinvested for expansion purposes.
Dividend Yield Dividends per share 0.33 ÷ 30 0.41 ÷ 17
÷ Market Value per
share
1.1% 2.41%
A low dividend yield would indicate that an investor would chose ABC Inc. as an investment
more for its long-term capital appreciation than for its dividend yield.

SUMMARY OF FINANCIAL STATEMENT ANALYSIS

Short term liquidity and activity

ABC’s current and quick ratios decreased indicating a deterioration of short term liquidity. The
average collection period for accounts receivable and the inventory turnover improved in 2018
which could indicate improvement in the quality of accounts receivable and liquidity of inventory.
The increase in inventory level has been accomplished by reducing holdings of cash and cash
equivalents. This represents a trade-off of highly liquid assets for potentially less liquid assets.
The efficient management of inventories is critical for the firm’s ongoing liquidity.

Long Term Solvency

The debt ratios for ABC show a steady increase in the use of borrowed funds. Total debt has
increased relative to total assets, long term debt has increased as a proportion of the firm’s
permanent financing and external or debt financing has risen relative to internal financing. Given
the increased level of borrowing, the TIE and fixed charge coverage improved slightly in 2018.
These ratios should however be monitored closely in the future particularly if ABC continues to
expand.

Operating Efficiency and Profitability

As noted earlier, ABC has increased its investment in fixed assets as a result of store expansion.
The asset TO increased in 2018, the progress traceable to improved management of inventories
and receivables. There has been substantial sales growth which suggests future performance
potential.

The gross profit margin was stable, a positive sign in the light of new store openings featuring
discounted and “sale” items to attract customers. The firm also managed to improve its operating
profit margin in 2018 principally due to the firm’s ability to control operating costs. The net profit
margin also improved despite increased interest and tax expenses and a reduction in interest
income from marketable security investment.

Return on asset and return on equity increased considerably in 2018. These ratios measure the
overall success of the firm in generating profits from its investment and management strategies.

CONCLUSION:
It appears that ABC Enterprises, Inc. is well positioned for future growth. Close monitoring the
firm’s management of inventories is important considering the size of the company’s capital tied
up in it. The expansion in their operation may necessitate a sustained effort to advertise more,
to attract customers to both new and old areas. ABC has financed much of its expansion with
debt, and so far, its shareholders have been benefited from the use of debt through financial
leverage. The company should however be cautious of the increased risk associated with debt
financing.