QUARTER 1 – MODULE 5

Analysis and Interpretation of Financial

Statements

Department of Education ● Republic of the Philippines

Fundamentals of Accountancy, Business and Management 2 - Senior High School
Alternative Delivery Mode
First Edition, 2020

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Introductory Message

Dear Teachers and Learners! The writer welcomes you all to this module for the
subject Fundamentals of Accountancy, Business and Management 2 in the ABM Strand of
Senior High School. The discussion focussed on the preparation of financial statements and
its analyses to determine the profitability, liquidity and solvency of the business.
As your partner in learning, I hope that you will not miss out every detail that the
writer would like you to learn in this material. Do enjoy as there are challenging and
interesting activities inside this learning modules. Congratulations in advance for this will
make you the master of your own learning.
Ops! wait for a while, for an easy use of this material, take note of some few
reminders:
1. Take your time to read every detail that this module contains.
2. This material contains Module 5 and each of which is provided with activities/tests
that will surely lead you to learn.
3. Here are the Icons used as your guide in every part of the lesson.

Icons of this Module

What I Need to This part contains learning objectives
that are set for you to learn as you go
Know along the module.
This is an assessment as to your level
of knowledge to the subject matter at
What I know
hand, meant specifically to gauge prior
related knowledge.
This part connects previous lesson with
What’s In that of the current one.

This is an introduction of the new lesson

What’s New through various activities before it will
be presented to you
This is a discussion of the activities as a
What is It way to deepen your discovery and
understanding of the concept.
This is a follow-up activity that is
What’s More intended for you to practice further in
order to master the competencies.

What I Have This activity is designed to process

what you have learned from the lesson
Learned

This is a task that is designed to

showcase your skills and knowledge
What I can do
gained, and applied into real-life
concerns and situations.

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 This is a task which aims to
evaluate your level of mastery in
Assessment achieving the learning competency.

In this portion, another activity will

Additional be given to you to enrich your
Activities knowledge or skill of the lesson
learned. This also tends retention
of learned concepts.

Answer Key This contains answers to all

activities in the module.

At the end of this module you will also find:

References This is a list of all sources used in

developing this module.

4. Please do follow the directions given per activity so your experience to the use of
this material will be meaningful and fruitful.
5. Answer all the tests in this material.
6. As a courtesy to the future users, PLEASE DO NOT WRITE ANYTHING ON ANY
PART OF THIS MODULE. Write your answer/s on a separate sheet of paper,
notebook, workbook or whichever is specified by your teacher/facilitator

Special Reminders for you learners:

1. Answer every activity intelligently and diligently.
2. Write your answer as directed by your teacher/facilitator.
3. Feel free to approach or communicate your teacher/facilitator whenever you
need help.
4. Don’t forget to put a smiley face if you finish the activity within the allotted time.

Table of Contents

iv
 Page
What This Module is all About…………………………………………………… ii
Introductory Message………………………………………………………......... iii
Icons of this Module………………………………………………………………. iii
MODULE Analysis & Interpretation of Financial Statements…….….. 1
What I Need to Know…………………………………………………………….. 1
What I Know (Pre-Test)………………………………………………………….. 2
LESSON 5 Analysis & Interpretation of Financial Statements ……………… 3
What’s In…………………………………………………………………………… 3
What’s New ……………………………………………………………………….. 4
Activity 5.1 Analyze Me……………………………………… 5

What is it Lesson 5.1 Horizontal versus Vertical Analysis…………... 6

Lesson 5.2 Different Financial Ratios ……………………... 10

What’s More

Activities
5.2 Compare & Contrast……………………….
5.3 Classify & Complete Me………………….. 10
What I Have Learned 5.4 Supply the Missing Link………………….. 21
What I Can Do 5.5 Solving the Problem ……………………… 22
Assessment 5.6 Choosing the Right One (Post-test)……… 24

Answer Key………………………………………………………………………………..27

References……………………………………………………………………………….. 32

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 5
Less
Analysis and Interpretation of Financial
on Statements

What I Need To Know

In this module you are dealing with the fundamental principles, tools, and
techniques of the financial operation involved in the management of business
enterprises. Thus, it covers on the basic framework and tools for financial analysis
and financial planning and control, and introduces basic concepts and principles
needed in making investment and financing decisions.

At the end of this lesson, you are expected to define the measurement levels,
namely: liquidity, solvency, and profitability. You will perform vertical and horizontal
analyses of financial statements of a single proprietorship. Moreover, you will
compute and interpret financial ratios such as current ratio, working capital, gross
profit ratio, net profit ratio, receivable turnover, inventory turnover, and debt-to-equity
ratio.

What I Know

Pre-test
Before starting with this module, let us see what you already know about the
Analysis and Interpretation of Financial Statements. Answer the questions below.
Directions. Read and analyze each item carefully. Write the correct letter of your answer on
a separate sheet and this corresponds to 1 point each.
1. Which of the following cannot be used to analyse financial statements?
A. Liquidity ratios
B. Solvency ratios
C. Profitability ratios
D. None of the above

2. This is the excess of current assets over current liabilities.

A. Working Capital
B. Current ratio
C. Acid test ratio
D. Quick ratio

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3. This is the availability of resources to meet short term cash requirements.
A. Liquidity
B. Solvency
C. Profitability
D. None of the above

4. Which of the following is not considered as a quick asset?

A. Cash
B. Inventory
C. Accounts Receivable
D. None of the above

5. Which of the following is considered as a quick asset?

A. Prepaid asset
B. Trading securities
C. Both A & B
D. None of the above

6. This measures the frequency of accounts receivable converted into cash.

A. Accounts receivable turnover ratio
B. Average collection period
C. Both A & B
D. None of the above

7. This is the entity’s ability to meet long term obligations as they become due.
A. Liquidity
B. Solvency
C. Profitability
D. None of the above

8. This compares the liabilities of the company with its equity.

A. Debt to total assets ratio
B. Debt to equity ratio
C. Both A & B
D. None of the above

9. Is the quotient of the current assets divided by the current liabilities of the
company?
A. Current ratio
B. Working capital ratio
C. Acid test ratio
D. None of the above

10. This ratio measures the proportion between the net income after tax and the
net sales of the company.
A. Profit margin ratio
B. Gross profit ratio
C. Both A & B
D. None of the above

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 11. This measures the capability of an entity to pay long term obligations as they
fall due.
A. Debt to equity ratio
B. Solvency ratio
C. Both A & B
D. None of the above

12. This ratio measures the frequency of conversion of the company’s accounts
receivable to cash.
A. Acid test ratio
B. Accounts receivable turnover ratio
C. Accounts payable turnover ratio
D. None of the above

13. This ratio measures the number of times the company was able to sell its
entire inventory to customers during the year.
A. Inventory turnover ratio
B. Average days in inventory
C. Number of days in operating cycle
D. None of the above

14. This is the proportion between the total liabilities of the company and its total
assets
A. Debt to Equity ratio
B. Times interest earned ratio
C. Debt to total assets ratio
D. None of the above

15. This is the proportion of the gross profit of the company with its net sales.
A. Profit margin ratio
B. Gross profit ratio
C. Both A & B
D. None of the above.

What’s In

In an earlier discussion of this module, you are being introduced to the

different financial statements that are being prepared by an entity. These financial
statements, which are prepared on a periodic basis, are composed of the following:

1. Statement of Financial Position or Balance Sheet

2. Statement of Comprehensive Income or Income Statement
3. Statement of Changes in Equity
4. Statement of Cash Flow

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 It is not enough that the accountant can prepare the said financial statements
correctly. Its importance lies in the ability of the company to make use of such
financial data in their decision making. The relevance of such documents can only be
achieved if it could make a positive impact on the day to day decisions being made
by the entity.

What’s New

To achieve the objectives of this lesson, you must remember to do the following:
 Read the lessons carefully.
 Follow all directions and given instructions.
 Answer all given tests and activities.
 Learn to familiarize the following terms:

TERM DEFINITION

Financial statement (FS) analysis With the objective of making an economic

decisions, this is a process of evaluating
risks, performance, financial health, and
future prospects of a business by subjecting
financial statement data to computational
and analytical techniques.

Horizontal analysis Trend analysis is the other name for this. It

is a technique for evaluating a series of
financial statement data over a period of
time with the purpose of determining the
increase or decrease that has taken place.
This will reveal the behavior of the account
over time. This Horizontal analysis also
uses financial statements of two or more
periods.

Vertical analysis This is also known as the common-size

analysis, it is a technique that expresses
each financial statement item as a
percentage of a base amount.

Ratio analysis It used to express the relationship among

selected items of financial statement data.
The relationship is expressed in terms of
percentage, rate, or a simple proportion.

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Activity 5.1. Analyze Me

Presented below is the Audited Annual Report of Jollibee Foods Corporation

for the year 2012 & 2013. Examine closely the data presented and answer the
questions that follow:

PSE Disclosure Form 17-1 - Annual Report References: SRC Rule 17 and
Sections 17.2 and 17.8 of the Revised Disclosure Rules
Balance Sheet
Year Ending Previous Year Ending
Dec 31, 2013 Dec 31, 2012
Current Assets 18,384,176,985 15,623,201,915
Total Assets 46,026,634,113 41,768,130,710
Current Liabilities 15,618,612,677 16,621,232,643
Total Liabilities 22,665,694,036 20,036,827,682
Retained
19,017,166,243 17,871,154,204
Earnings/(Deficit)
Stockholders' Equity 23,360,940,077 21,731,303,028
Stockholders' Equity - Parent 22,548,878,780 20,998,202,046
Book Value per Share 22.20 20.75
Income Statement
Year Ending Previous Year Ending
Dec 31, 2013 Dec 31, 2012
Operating Revenue 80,282,769,199 71,059,039,154
Other Revenue 221,764,423 452,580,461
Gross Revenue 80,504,533,622 71,511,619,615
Operating Expense 74,351,672,804 66,714,021,369
Other Expense -92,653,780 -64,101,457
Gross Expense 74,259,019,024 66,649,919,912
Net Income/(Loss) Before Tax 6,245,514,598 4,861,699,703
Income Tax Expense 1,522,708,071 1,149,704,051
Net Income/(Loss) After Tax 4,722,806,527 3,711,995,652
Net Income/(Loss) Attributable to Parent
4,671,559,394 3,727,084,297
Equity Holder
Earnings/(Loss) Per Share (Basic) 4.450 3.577
Earnings/(Loss) Per Share (Diluted) 4.360 3.513

(Source: Philippine Stock Exchange,

https://edge.pse.com.ph/openDiscViewer.do?edge_no=5b3feb584ad68ec41db82e377ee70f3b)

Processing Questions:

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 1. How much is JFC’s total assets as of December 31, 2013?
2. How much of JFC’s liabilities are due to be paid on or before December 31,
2014?
3. What is the asset growth in 2013?
4. Is the asset composition in 2012 the same as that in 2013?
5. Is the revenue growth in 2013 better than that in 2012?
6. Is the net income growth in 2013 better than that in 2012?

Points to remember:
 The above questions are just examples of information that the owners or chief
executive officer (CEO) of JFC needs to know in order to make business
decisions.
 It can be concluded from the above exercise that not all information needed
by the CEO are readily available on the face of the FS.
 The topics in this module will allow you to derive meaningful information from
the financial statements than just the amounts reported on the face of the FS.

What Is It

Lesson 5.1 Horizontal Analysis versus Vertical Analysis

The two most basic tools that could be used by entities in analyzing their own
financial statements are horizontal analysis and vertical analysis.

In horizontal analysis, the company compares their own financial statements

for the current period with their financial statements from the previous period. The
amount of the prior period normally serves as the basis or the starting point of the
comparison. Increases or decreases amounts are being taken and it will be
measured in percentages. Below is the sample of horizontal analysis of XYZ
Company:

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Sample Balance Sheet of XYZ Company for the year 2018 and 2019.

XYZ COMPANY XYZ COMPANY

Balance sheet Balance sheet
As of December 31, 2018 As of December 31, 2019
ASSETS: ASSETS:
Cash 450,000.00 Cash 510,000.00
Accounts Receivable 130,000.00 Accounts Receivable 90,000.00
Inventory 65,000.00 Inventory 70,000.00
Land 655,000.00 Land 710,000.00
Patent 80,000.00 Patent 100,000.00
Total Assets 1,380,000.00 Total Assets 1,480,000.00
LIABILITIES: LIABILITIES:
Accounts Payable 360,000.00 Accounts Payable 400,000.00
Notes Payable 230,000.00 Notes Payable 270,000.00
Total Liabilities 590,000.00 Total Liabilities 670,000.00
OWNER’S EQUITY: OWNER’S EQUITY:
Owner’s, Capital 790,000.00 Owner’s, Capital 810,000.00
Total Liabilities & 1,380,000.00 Total Liabilities & 1,480,000.00
Owner’s Equity Owner’s Equity

To conduct horizontal analysis, compare both accounting periods:

XYZ COMPANY
Horizontal Analysis of Balance Sheet
For the year 2018 & 2019
ASSETS: 2018 2019 Amount Percentage
Increase Increase
(Decrease) (Decrease)
*current *amount /
year – previous year
previous
year
Cash 450,000.00 510,000.00 60,000.00 13.33%
Accounts Receivable 130,000.00 90,000.00 (40,000.00) (30.77%)
Inventory 65,000.00 70,000.00 5,000.00 7.69%
Land 655,000.00 710,000.00 55,000.00 8.40%
Patent 80,000.00 100,000.00 20,000.00 25.00%
Total Assets 1,380,000.00 1,480,000.00 100,000.00 7.25%
LIABILITIES:
Accounts Payable 360,000.00 400,000.00 40,000.00 11.11%
Notes Payable 230,000.00 270,000.00 40,000.00 17.39%
Total Liabilities 590,000.00 670,000.00 80,000.00 13.56%
OWNER’S EQUITY:
Owner’s, Capital 790,000.00 810,000.00 20,000.00 2.53%
Total Liabilities & 1,380,000.00 1,480,000.00 100,000.00 7.25%
Owner’s Equity

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To interpret: For example in Cash item

✓Peso change = P510,000 – P450,000 = P60,000

✓Percentage change = P60,000 / P450,000 = 13.33%
✓This is evaluated as follows: Cash increased by P60,000. This represents growth
of 13.33% from the year 2018.

The previous period (2018) is the basis or the starting point of the comparison.
Through this kind of analysis, the company would easily identify the items that made
substantial movements during the second year (2019).

Aside from the Statement of Financial Position, companies can also make use
of horizontal analysis to analyze Income Statements of companies.

Taken, side by side, a horizontal analysis of XYZ Company’s Income Statement

would look like this:

XYZ COMPANY
Horizontal Analysis of Income Statement
For the year 2018 & 2019
2018 2019 Amount Percentage
Increase or Increase or
(Decrease) (Decrease)
Net Sales 880,000.00 950,000.00 70,000.00 7.95%
Less: Cost of Goods Sold 260,000.00 180,000.00 ( 80,000.00) (30.77%)
Gross Profit 620,000.00 770,000.00 150,000.00 24.19%
Less: Operating Expenses 140,000.00 180,000.00 40,000.00 28.57%
Operating Income 480,000.00 590,000.00 110,000.00 22.92%
Less: Interest Expense 65,000.00 25,000.00 ( 40,000.00) (61.54%)
Net Income before Tax 415,000.00 565,000.00 150,000.00 36.14%
Less: Income Tax Expense 124,500.00 180,000.00 55,500.00 44.58%
Net Income after Tax 290,500.00 385,000.00 94,500.00 32.53%

To interpret: For example in Net Sales item

✓Peso change = P950,000 – P880,000 = P70,000

✓Percentage change = P70,000 / P950,000 = 7.95%
✓ This is evaluated as follows: net Sales increased by P70,000. This represents
growth of 7.95% from the year 2018.

In vertical analysis, companies express items of a certain financial statement

as a percentage of a given base amount. For example, items on a Balance Sheet
are normally compared to the total assets of the company for that given year. Items

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in an Income Statement are normally compared to the Net Sales for that given
accounting period.
Let us take as example the Balance sheet and Income Statement of XYZ
Company for the year 2018 and 2019 as illustrated above. In preparing a vertical
analysis of financial statements, the Total Assets and the Net Sales will serve as
the base amount or the 100%. All of the items in the Balance Sheet and in the
Income Statement will be divided using the base amount.

To illustrate, the vertical analysis of XYZ Company’s Financial Statements are

placed below:
XYZ COMPANY
Vertical Analysis of Balance Sheet
As of December 31, 2018
ASSETS: Percentage
*(item / total assets)
Cash 450,000.00 32.61%
Accounts Receivable 130,000.00 9.42%
Inventory 65,000.00 4.71%
Land 655,000.00 47.46%
Patent 80,000.00 5.80%
Total Assets 1,380,000.00 100.00%
LIABILITIES:
Accounts Payable 360,000.00 26.09%
Notes Payable 230,000.00 16.67%
Total Liabilities 590,000.00 42.75%
OWNER’S EQUITY:
Owner’s, Capital 790,000.00 57.25%
Total Liabilities & Owner’s Equity 1,380,000.00 100.00%

The above may be evaluated as follows:

The largest component of assets is Land at 47.46% followed by Cash which is
32.61%.
Patent is the smallest component at 5.80%.
On the other hand, 42.75% of assets are financed by debt and the remaining
57.25% is financed by equity.

XYZ COMPANY
Vertical Analysis of Income Statement
As of December 31, 2018
Percentage
*(item / net sales)
Net Sales 880,000.00 100.00%
Less: Cost of Goods Sold 260,000.00 29.55%
Gross Profit 620,000.00 70.45%
Less: Operating Expenses 140,000.00 15.91%
Operating Income 480,000.00 54.54%
Less: Interest Expense 65,000.00 7.39%
Net Income before Tax 415,000.00 47.15%

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Less: Income Tax Expense 124,500.00 14.14%
Net Income after Tax 290,500.00 33.01%

The above may be evaluated as follows:

 The cost of goods sold is 29.55% of sales. The company has a gross profit
rate of 70.45%. Operating expenses are 15.91% of sales.
 The company earns income of P 0.33 for every peso of sales.
 Gross profit generated for every peso of sale is P 0.70

Lesson 5.2. Different Financial Ratios

Financial ratios in accounting can be classified into three groups:

1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios

Liquidity Ratios

Liquidity is the capacity of a company to pay its currently maturing obligations.

These would 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 the short term creditors of a company. It will
determine if the borrowing company is in a position to pay the borrowed principal and
interest when they fall due.

To better understand the financial ratios, let us have an illustrative example of

the computation using the sample Financial Statements of GSM Company shown
below:

GSM COMPANY
Comparative Balance Sheet
For the Year 2018 and 2019
ASSETS 2018 2019
Cash 450,000.00 500,000.00
Accounts Receivable 300,000.00 330,000.00
Trading Securities 170,000.00 80,000.00
Inventories 420,000.00 470,000.00
Prepaid Expenses 70,000.00 130,000.00
Total Current Assets 1,410,000.00 1,510,000.00

Total Noncurrent Assets 890,000.00 1,190,000.00

Total Assets 2,300,000.00 2,700,000.00

LIABILITIES
Total Current Liabilities 450,000.00 500,000.00
Total Noncurrent Liabilities 1,150,000.00 1,350,000.00
Total Liabilities 1,600,000.00 1,850,000.00
OWNER’S EQUITY

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Total Owner’s Equity 700,000.00 850,000.00
Total Liabilities & owner’s Equity 2,300,000.00 2,700,000.00

GSM COMPANY
Comparative Income Statement
For the Year 2018 and 2019
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Less: Cost of Goods Sold 1,000,000.00 1,300,000.00
Gross Profit 4,000,000.00 4,500,000.00
Less: Operating Expenses 800,000.00 300,000.00
Earnings Before Interest and Taxes 3,200,000.00 4,200,000.00
Less: Interest Expense 300,000.00 1,800,000.00
Net Income before Tax 2,900,000.00 2,400,000.00
Less: Income Tax Expense 550,000.00 400,000.00
Net Income after Tax 2,350,000.00 2,000,000.00

Different ratios under liquidity ratio are shown below:

1. Working Capital
Liquidity 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 of the current liabilities at the moment.
Formula: Working Capital = Current Assets – Current Liabilities
Using the GSM Company data, we would be able to compute the company’s
working capital for 2018 and 2019.
2018 2019
Current Assets 1,410,000.00 1,510,000.00
Less: Current Liabilities 450,000.00 500,000.00
Working Capital 960,000.00 1,010,000.00

Analysis: For both periods, the company has a positive working capital. This is
something good. However, comparing the two periods, we can conclude that
GSM Company is in a better liquidity position in the year 2019 than in 2018.

2. Current Ratio
Current ratio is the quotient of current assets divided by the current
liabilities of the company. As much as possible, a whole number
current ratio is preferred.
Formula: Current Ratio = Current Assets / Current Liabilities
Using the GSM Company data, we would be able to compute the company’s
current ratio for 2018 and 2019.
2018 2019
Current Assets 1,410,000.00 1,510,000.00
Divided by: Current Liabilities 450,000.00 500,000.00
Current Ratio 3.13 3.02

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 Analysis: GSM Company has P 3.13 worth of current assets for every P 1.00
of current liabilities for the year 2018. This is something positive. However,
comparing the two periods, the company has a slightly better current ratio in
2018 than in 2019.

3. Acid Test Ratio

Acid Test Ratio is a more strict variation of the current ratio formula. It
removes Inventory and Prepaid Expenses from the numerator
component. Only Cash, Receivables, and Trading Securities also
known as Quick Assets will be left.

Formula: Acid Test Ratio = Quick Assets / Current Liabilities

Using the GSM Company data, we would be able to compute the company’s
acid test ratio for 2018 and 2019.
2018 2019
Quick Assets 920,000.00 910,000.00
Divided by: Current Liabilities 450,000.00 500,000.00
Acid Test Ratio 2.04 1.82

Analysis: GSM Company has P 2.04 worth of quick assets for every P 1.00 of
current liabilities for the year 2018. This is something positive. It means that it
really has the capability to pay its maturing obligations through its quick
assets. Comparing both years, however, would reveal that the company was
better off in 2018 than in 2019.

4. Accounts Receivable Turnover Ratio

This ratio measures the frequency of conversion of the company’s
Accounts Receivable to Cash. It measures how many times the
company collected its Accounts Receivable from its customers.

Formula: Accounts Receivable Turnover Ratio = Net Sales/Accounts Receivable

Using the GSM Company data, we would be able to compute the company’s
accounts receivable turnover ratio for 2018 and 2019.
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Divided by: Accounts 300,000.00 330,000.00
Receivable
Accounts Receivable 16.66 times 17.57 times
Turnover Ratio

Analysis: Comparing the compound Accounts Receivable Turnover

Ratios for the two years, it can be seen that the company has a higher ratio

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 for 2019. 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 it would
take before the company would be able to collect a certain group of
receivables. The Accounts Receivable 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 depending on the policy of the company.
Formula: Average Collection Period = 365 days / A/R Turnover Ratio
Using the GSM Company data, we would be able to compute the company’s
average collection period for 2018 and 2019.
2018 2019
No. of days 365 365
Divided by: Accounts Receivable 16.66 17.57
Turnover Ratio
Average Collection Period 21.91 days 20.77 days

Analysis: The shorter average collection period in 2019 shows that the
collection department increased its efforts to collect company receivables as
they fall due. It can be seen in our computation that the company has a better
Accounts Receivables Turnover Ratio and Average Collection Period in 2019
than in 2018. A shorter average collection period means that the company
has more immediate cash that can be used in its operation.

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 ratio. A high turnover ratio shows
how efficient the company is in selling its inventory to customers.

Formula: Inventory Turnover Ratio = Cost of Goods Sold / Inventory

Using the GSM Company data, we would be able to compute the company’s
inventory turnover ratio for 2018 and 2019.
2018 2019
Cost of Goods Sold 1,000,000.00 1,300,000.00
Divided by: Inventory 420,000.00 470,000.00
Inventory Turnover Ratio 2.38 times 2.76 times

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 Analysis: It can be seen in our computation that the inventory slightly
increased in 2019. It means that the sales department sold more products to
customers in 2019.

7. Average Days in Inventory

This ratio states 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 goal is to have
shorter average days in inventory. A shorter amount would mean that
the cash of the company is not being tied to its inventory for a very long
period of time.

Formula: Average Days in Inventory = No. of days / Inventory Turnover Ratio

Using the GSM Company data, we would be able to compute the company’s
average days in inventory for 2018 and 2019.
2018 2019
No. of days 365 365
Divided by: Inventory 2.38 2.76
Turnover Ratio
Average Days in Inventory 153.36 days 132.25 days

Analysis: This means that the company will take 153 days to sell its
entire inventory for the year 2018 while it would only take 132 days for the
year 2019. The average days in inventory of this company improved in 2019.
This is because the inventory turnover in 2019 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 days of operating cycle.

Formula: No. of Days in Operating Cycle = Average Collection Period +

Average Days in Inventory
Using the GSM Company data, we would be able to compute the company’s
no. of days in the operating cycle for 2018 and 2019.
2018 2019
Collecting Period 21.91 20.77
Add: Days in Inventory 153.36 132.25
No. of days in Operating 175.27 days 153.02 days
Cycle

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 Analysis: A comparison between the two periods shows an
improvement of at least 22 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.

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 payable and bond
payable will be interested in knowing its solvency ratios.

1. Debt to Total Assets Ratio

This is the proportion between the total liabilities of the company and
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 want a very low debt to total assets ratio.

Formula: Debt to Total Assets Ratio = Total Liabilities / Total Assets

Using the GSM Company data, we would be able to compute the company’s
debt to total assets ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Debt to Total Assets Ratio .69 .68

Analysis: Comparing the data for the two years involved, it can be seen
that there is a minimal change in the debt ratio of the company. This means
that in 2018, out of the total assets of the company, 69% was being financed
by creditors. A high debt to asset ratio implies a high level of debt.

2. Debt to Equity Ratio

Instead of assets, the debt to equity ratio compares the liabilities of the
company with its equity. A smaller debt to equity ratio would indicate a
healthier solvency position for the company.

Formula: Debt to Equity Ratio = Total Liabilities / Total Owner’s Equity

Using the GSM Company data, we would be able to compute the company’s
debt to equity ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Owner’s Equity 700,000.00 850,000.00
Debt to Equity Ratio 2.28 2.17

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 Analysis: Comparing the debt to equity ratio of the company for two
periods concerned showed that the company was more solvent in 2019 than
in 2018. A high ratio suggests a high level of debt that may result in high
interest expense.

3. Times Interest Earned Ratio

The Time Interest Earned Ratio shows the proportion between the
Earnings Before Interest and Taxes (EBIT) of the company and its
interest expense. It is an indicator of how many times the company’s
EBIT can cover the finance cost of borrowing. Companies want a high
Times Interest Earned Ratio. A small or decimal number ratio indicates
that it is not advisable for a company to borrow money – especially if
the company would not be able to generate enough income to cover it.

Formula: Times Interest Earned Ratio = EBIT / Interest Expense

Using the GSM Company data, we would be able to compute the company’s
times interest earned ratio for 2018 and 2019.
2018 2019
Earnings Before Income Tax 3,200,000.00 4,200,000.00
Divided by: Interest Expense 300,000.00 1,800,000.00
Times Interest Earned Ratio 10.66 2.33

Analysis: Comparing the times interest earned ratio of the company for
two periods, it can be seen that the company is very solvent in the year 2018
compared to that in 2019. It is 10 times more solvent to pay the interest with
its income before tax.

Profitability Ratios
Profitability ratios measure the ability of the company to generate income from
the use of its assets and invested capital as well as control its cost. The following are
the commonly used profitability ratios:
1. Gross Profit Ratio
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. A company should aim for a
bigger gross profit ratio. A large gross profit ratio shows that a
company can generate more sales from the smaller cost of goods sold
that it has.

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Formula: Gross Profit Ratio = Gross Profit / Net Sales
Using the GSM Company data, we would be able to compute the company’s
gross profit ratio for 2018 and 2019.
2018 2019
Gross Profit 4,000,000.00 4,500,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Profit Ratio 80% 77.59%

Analysis: This means that for every P 1.00 the company sells, P .80
goes to the gross profit in the year 2018. The company’s gross profit ratio
slightly decreased in 2019. 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 Ratio
The profit 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 measurement of the company’s
profitability because it has already considered the operating expenses
and other expenses of the entity. Companies want a high profit margin
ratio.

Formula: Gross Margin Ratio = Net Income after Tax / Net Sales
Using the GSM Company data, we would be able to compute the company’s
gross margin ratio for 2018 and 2019.
2018 2019
Net Income after Tax 2,350,000.00 2,000,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Margin Ratio 47% 34.48%

Analysis: This means that company earned P .47 for every P 1.00 of
sales in the year 2018. The company’s gross margin ratio shows a decline for
the year 2019. This can be attributed to the lower NIAT coupled by an
increase in Net Sales.

3. Operating Expenses to Sale 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. This
ratio should be minimized as much as possible. The goal is to generate
as much sales with the minimum operating expenses.

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Formula: Operating Expenses to Sale Ratio = Operating Expenses / Net Sales

Using the GSM Company data, we would be able to compute the company’s
operating expenses to sale ratio for 2018 and 2019.
2018 2019
Operating Expenses 800,000.00 300,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
OE to Sale Ratio 16% 5.17%

Analysis: 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 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 = NIAT / Total Assets

Using the GSM Company data, we would be able to compute the company’s
return on assets for 2018 and 2019.
2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Return on Assets 1.02 0.74

Analysis: Comparing the data for the two years involved shows that in
the year 2018 the return on assets is very high compared to the year 2019.
This can be attributed to a much higher income compared to the assets of the
company.

5. Return on Equity
This is a slight variation of the earlier formula. In this case, it is the
average owner’s/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/owners alone.

Formula: Return on Equity = NIAT / Owner’s Equity

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 Using the GSM Company data, we would be able to compute the company’s
return on equity for 2018 and 2019.
2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Owner’s Equity 700,000.00 850,000.00
Return on Equity 3.36 2.35

Analysis: In 2019, the return on equity decreased. This could be

attributed to a lower net income after tax and a larger owner’s equity.

6. Asset Turnover Ratio

This ratio measures the correlation between the assets owned by the
company and the net sales generated by such properties.

Formula: Assets Turnover Ratio = Net Sales / Total Assets

Using the GSM Company data, we would be able to compute the company’s
assets turnover ratio for 2018 and 2019.
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Assets Turnover Ratio 2.17 2.15

Analysis: The assets turnover ratio slightly decreased in 2019. This is

something not good because the company should aim for a higher assets
turnover ratio. This can be attributed to bigger net sales generated for that
year.

What’s More

Activity 5.2 Compare and Contrast.

1. Compare and contrast liquidity ratio and solvency ratio.

___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
_________________________________________________ .

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 2. Compare and contrast profitability ratio and solvency ratio.
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
_________________________________________________ .

3. Compare and contrast horizontal analysis and vertical analysis.

___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
___________________________________________________________
_________________________________________________ .

Activity 5.3 Classify and Complete Me.

Directions: Classify the following ratios by indicating whether liquidity, solvency or

profitability and complete the table with its corresponding formula.

RATIOS CLASSIFICATION FORMULA

NIAT
Ex. Return on Assets Profitability ---------------
Total Assets

Debt to Equity Ratio

Return on Equity

Current Ratio

Debt to Total Assets Ratio

Acid Test Ratio

Profit Margin Ratio

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Average Collection Period

Times Interest Earned Ratio

Inventory Turnover Ratio

Operating Expense to Sales

Ratio

What I Have Learned

Activity 5.4 Supply the Missing Link

Instruction: Now that you have already finished learning the concepts, let us see
what you have learned so far by supplying the appropriate word(s) on the blank.

_________________ is the capacity of a company to pay its currently

maturing obligations. These would require a good amount of liquid assets like
__________________, ____________________, __________________ and other
assets such as inventory and prepaid expenses. ________________________ are
very important to the short terms creditors of a company.

__________________ ratios measure the capability of an entity to pay long

term obligations as they fall due. _______________ of the company’s long-term
notes payable and bonds payable will be interested in knowing its solvency ratios.

Lastly, _________________ ratios are used to determine the profitability or

performance of a company.

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 What I Can Do

Activity 5.5. Solving the Problem

Presented below is the Comparative Financial Statements of Tan General

Merchandise for the year 2018 and 2019:

TAN GENERAL MERCHANDISE

Comparative Statement of Financial Position
For the Year 2018 & 2019
2018 2019
ASSETS
Cash 87,400.00 110,000.00
Accounts Receivable 69,920.00 90,000.00
Inventory 218,500.00 129,000.00
Prepaid Rent 4,370.00 12,000.00
Total Current Assets 380,190.00 341,000.00

Land 493,810.00 550,000.00

Building 500,000.00 600,000.00
Total Noncurrent Assets 993,810.00 1,150,000.00

TOTAL ASSETS 1,374,000.00 1,491,000.00

LIABILITIES
Accounts Payable 250,000.00 200,000.00
Notes payable 150,000.00 300,000.00
Total Current Liabilities 400,000.00 500,000.00

Mortgage Payable 160,000.00 180,000.00

Loan Payable 150,000.00 200,000.00
Total Noncurrent Liabilities 310,000.00 380,000.00

TOTAL LIABILITIES 710,000.00 880,000.00

OWNER’S EQUITY
Tan, Capital 664,000.00 611,000.00
Total Liabilities & Owner’s Equity 1,374,000.00 1,491,000.00

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 TAN GENERAL MERCHANDISE
Comparative Statement of Comprehensive Income
For the Year 2018 & 2019
2018 2019
Net Sales 686,000.00 810,000.00
Cost of Goods Sold 348,300.00 301,750.00
Gross Profit 337,700.00 508,250.00
Operating Expenses 205,800.00 234,900.00
Earnings Before Interest and Taxes 131,900.00 273,350.00
Interest Expense 17,150.00 40,500.00
Net Income Before Tax 114,750.00 232,850.00
Income Tax 34,425.00 69,855.00
Net Income After Tax 80,325.00 162,995.00

Required:

1. Prepare a horizontal analysis for the Comparative Statement of Financial

Position.
2. Prepare a vertical analysis for the Comparative Statement of Comprehensive
Income.
3. Compute the following ratios for the comparative periods. The company used
365 days in its computation for some of the ratios. Show your solution.
a. Working Capital
b. Current Ratio
c. Acid Test Ratio
d. Accounts Receivable Turnover Ratio
e. Average Collection Period
f. Inventory Turnover Ratio
g. Average Days in Inventory
h. Number of days in Operating Cycle
i. Debt to Total Assets Ratio
j. Debt to Equity Ratio
k. Times Interest Earned Ratio
l. Gross Profit Ratio
m. Profit Margin Ratio
n. Return on Assets
o. Return on Equity
p. Assets Turnover Ratio

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 Assessment

Activity 5.6 Choosing the Right One (Post-test)

Now, that you are finished accomplishing the module, let us check further
what you have learned. Write the correct letter of your answer on a separate sheet
and this corresponds to 1 point each.

1. Which of the following cannot be used to analyse financial statements?

A. Liquidity ratios
B. Solvency ratios
C. Profitability ratios
D. None of the above.

2. This is the availability of resources to meet short term cash requirements.

A. Liquidity
B. Solvency
C. Profitability
D. None of the above

3. This is the excess of current assets over current liabilities.

A. Working Capital
B. Current ratio
C. Acid Test ratio
D. Quick ratio

4. Which of the following is not considered as quick assets?

A. Cash
B. Inventory
C. Accounts Receivable
D. None of the above

5. Which of the following is considered as quick assets?

A. Prepaid asset
B. Trading securities
C. Both A & B
D. None of the above

6. This measure the frequency of accounts receivable converted into cash.

A. Accounts receivable turnover ratio
B. Average collection period
C. Both A & B
D. None of the above

7. This is the entity’s ability to meet long term obligations as they become due.
A. Liquidity
B. Solvency
C. Profitability
D. None of the above

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8. This compares the liabilities of the company with its equity.
A. Debt to total assets ratio
B. Debt to equity ratio
C. Both A & B
D. None of the above

9. Is the quotient of the current assets divided by the current liabilities of the
company?
A. Current ratio
B. Working capital ratio
C. Acid test ratio
D. None of the above

10. This ratio measures the proportion between the net income after tax and the
net sales of the company.
A. Profit margin ratio
B. Gross profit ratio
C. Both A & B
D. None of the above

11. This measures the capability of an entity to pay long term obligations as they
fall due.
A. Debt to equity ratio
B. Solvency ratio
C. Both A & B
D. None of the above

12. This ratio measures the frequency of conversion of the company’s accounts
receivable to cash.
A. Acid test ratio
B. Accounts receivable turnover ratio
C. Accounts payable turnover ratio
D. None of the above

13. This ratio measures the number of times the company was able to sell its
entire inventory to customers during the year.
A. Inventory turnover ratio
B. Average days in inventory
C. Number of days in operating cycle
D. None of the above

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 14. This is the proportion between the total liabilities of the company and its total
assets
A. Debt to Equity ratio
B. Times interest earned ratio
C. Debt to total assets ratio
D. None of the above

15. This is the proportion of the gross profit of the company with its net sales.
A. Profit margin ratio
B. Gross profit ratio
C. Both A & B
D. None of the above.

Congratulations! You have just finished Lesson 5 of this module.

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