SAINT ANTHONY ACADEMY OF GONZAGA SY 2021-2022

SUBJECT: CULMINATING ACTIVITY FOR ABM 12

LESSONS: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
PREPARD BY: KELVIN JAY S. SAPLA Email: [email protected]

PART I. INTRODUCTION
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.
PART II. STANDARDS
CONTENT: The learners demonstrate the methods or tools of analysis of financial statements to include horizontal analysis,
vertical analysis, and financial ratios to test the level of liquidity, solvency, profitability, and stability of the business
PERFORMANCE: solve exercises and problems that require computation and interpretation using horizontal analysis,
vertical analysis, and various financial ratios
Using the downloaded sample financial statements, he / she performs horizontal and vertical analysis, computes various
financial ratios and interprets the level of liquidity, solvency, stability, and profitability of the business
LEARNING COMPETENCIES: The learners…
1. define the measurement levels, namely, liquidity, solvency, stability, and profitability
2. perform vertical and horizontal analyses of financial statements of a single proprietorship
3. compute and interpret financial ratios such as current ratio, working capital, gross profit ratio, net profit ratio,
receivable turnover, inventory turnover, debt-to-equity ratio, and the like

PART III. TRANSFER

Transfer Goal: The leaners will be fully equipped with the knowledge and skills on the different
financial statements and be able to use it in the near future as an entrepreneurs, businessman and accountants.

DISCUSSION/ SUMMARY
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.
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
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
 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 Receivable 300,000.00 330,000.00
Accounts Receivable Turnover 16.66 times 17.57 times
Ratio

Analysis: Comparing the compound Accounts Receivable Turnover Ratios for the two years, it can be seen
that the company has a higher ratio 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 Turnover 16.66 17.57
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
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 Turnover 2.38 2.76
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 Cycle 175.27 days 153.02 days

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
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.
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.
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

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.

Activity 1: 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.

EVALUATION. PROBLEM SOLVING

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

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. 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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Josefina L. Beticon, J. C. (2017). Fundamentals of Accountancy, Business and Management 2 - Teacher's Manual. Vibal
Group. Inc. Reyes, V. D. (2017). Fundamentals of Accountancy, Business and Management 2. GIC Enterprises &
Co., Inc.
Salazar, D. R. (2017). Fundamentals of Accountancy, Business and Management 2. Rex Bookstore.