FINANCIAL STATEMENT ANALYSIS

Example 01:
Suppose a company is considering expanding its production plants. The expansion can increase
the net income before interest and tax by $30 million and requires a financing of $200 million.

The three proposed ways of financing are as follows:

1. By issuing common stock.

2. By issuing common stock and 8% preferred stock in the ratio of 1: 1.
3. By issuing common stock and 8% bonds in the ratio of 1: 1.

Required: Show computations how obtaining debt can be a more efficient way of generating
positive financial leverage than issuing preferred stock.

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The alternatives in above example generate different return on common stockholders’ equity.
The reason of the difference is explained below:

Alternative-1 generates 10.5% return on common stockholders’ equity, there is no debt or

preferred stock involved, the leverage is therefore zero.

Alternative-2 generates 13% return on common stockholders’ equity, the preferred stock is
present but there is no debt.

Alternative-3 generates 15.4% return on common stockholders’ equity which is the highest of
three alternatives. The reason is that the preferred stock is replaced with the debt. The interest on
debt is tax deductible while the dividend on preferred stock is not.

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Example 02:
The following information has been taken from the balance sheet of PQR limited:

Year 2011:
Common stockholders’ equity: $3,500,000
Preferred stock – 9%: $1,400,000
Bonds payable – 6%: $1,600,000

Year 2012:
Common stockholders’ equity: $2,800,000
Preferred stock – 9%: $1,800,000
Bonds payable – 6%: $1,400,000

We can compute the capital gearing ratio for the years 2011 and 2012 from the above
information as follows:

For the year 2011:

Capital gearing ratio = 3,500,000 / 3,000,000
= 7:6 (Low geared)

For the year 2012:

Capital gearing ratio = 2,800,000 / 3,200,000
= 7:8 (Highly geared)

The company has a low geared capital structure in 2011 and highly geared capital structure in
2012.

Highly geared >>> Less common stockholders’ equity

Low geared >>> More common stockholders’ equity

Significance and interpretation: Capital gearing ratio is the measure of capital structure
analysis and financial strength of the company and is of great importance for actual and potential
investors. Borrowing is a cheap source of funds for many companies but a highly geared
company is considered a risky investment by the potential investors because such a company has
to pay more interest on loans and dividend on preferred stock and, therefore, may have to face
problems in maintaining a good level of dividend for common stockholders during the period of
low profits.
Banks and other financial institutions reluctant to give loans to companies that are already highly
geared.

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Example 03:
For example, suppose a company has current assets valuing $650,000 and stockholders’
equity $4,500,000. The current assets to equity ratio would be computed as follows:

= $650,000 / $4,500,000
= 0.14 or 14%

Significance and interpretation:

There is no norm; the ratio varies from industry to industry. Like fixed assets to equity ratio, it is
used as a complementary ratio to proprietary ratio.

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Example 04:
The finance manager of Bright Future Inc., wants to evaluate the long term solvency position of
the company. He has extracted the following data from the financial statements of the company:

Fixed assets: $1,290,000

Accumulated depreciation: $90,000
Total stockholders’ equity: $1,500,000

Required: Compute fixed assets to stockholders’ equity ratio as a part of the long term solvency
test of Bright Future Inc.

Solution:

= $1,200,000* / $1,500,000
0.8 Or 80% if expressed in percentage

*1,290,000 – 90,000 = 1,200,000

The ratio is less than 1. It means that all fixed assets and a portion of working capital of Bright
Future Inc., has been financed by the stockholders.

Significance and interpretation:

If fixed assets to stockholders’ equity ratio are more than 1, it means that stockholders’ equity is
less than the fixed assets and the company is using debts to finance a portion of fixed assets. If
the ratio is less than 1, it means that stockholders’ equity is more than the fixed assets
and the stockholders’ equity is financing not only the fixed assets but also a part of the working
capital.

Different industries have different norms. Generally a ratio of 0.60 to 0.70 (or 60% to 70%, if
expressed in percentage) is considered satisfactory for most of the industrial undertakings.

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Fixed assets to stockholders’ equity ratio are used as a complementary ratio to proprietary ratio.

Some analysts prefer to exclude intangible assets (goodwill etc.) from the denominator of the
above formula. In that case, the formula would be written as follows:

The information about stockholders’ equity and assets is available from balance sheet.

Example 05:

Total assets: $950,000

Intangible assets: $150,000
Stockholder’s equity: $440,000

From the above information we can compute proprietary ratio as follows:

(440,000 / 800,000) × 100

55%

The proprietary ratio is 55%. It means stockholders’ has contributed 55% of the total tangible
assets. The remaining 45% have been contributed by creditors.

Significance and interpretation:

The proprietary ratio shows the contribution of stockholders’ in total capital of the company. A
high proprietary ratio, therefore, indicates a strong financial position of the company and greater
security for creditors. A low ratio indicates that the company is already heavily depending on
debts for its operations. A large portion of debts in the total capital may reduce creditor’s
interest, increase interest expenses and also the risk of bankruptcy.

Having a very high proprietary ratio does not always mean that the company has an ideal capital
structure. A company with a very high proprietary ratio may not be taking full advantage of debt
financing for its operations that is also not a good sign for the stockholders.

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Income before interest and tax (i.e., net operating income) and interest expense figures are
available from the income statement.

Example 06:
A creditor has extracted the following data from the income statement of PQR and requests you
to compute and explain the times interest earned ratio for him.

Required: Compute times interest earned (TIE) ratio of PQR Company.

Solution:

= (2,570 / 320)
= 8.03 times

The times interest earned ratio of PQR company is 8.03 times. It means that the interest expenses
of the company are 8.03 times covered by its net operating income (income before interest and
tax).

Significance and Interpretation:

Times interest earned ratio is very important from the creditors view point. A high ratio ensures a
periodical interest income for lenders. The companies with weak ratio may have to face
difficulties in raising funds for their operations.

Generally, a ratio of 2 or higher is considered adequate to protect the creditors’ interest in the
firm. A ratio of less than 1 means the company is likely to have problems in paying interest on its
borrowings.

A very high times interest ratio may be the result of the fact that the company is unnecessarily
careful about its debts and is not taking full advantage of the debt facilities.

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Example 07:

ABC Company has applied for a loan. The lender of the loan requests you to compute the debt to
equity ratio as a part of the long-term solvency test of the company.

The “Liabilities and Stockholders’ Equity” section of the balance sheet of ABC company is
given below:

Required: Compute debt to equity ratio of ABC Company.

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Solution:

= 7,250 / 8,500
= 0.85

The debt to equity ratio of ABC Company is 0.85 or 0.85: 1. It means the liabilities are 85% of
stockholders equity or we can say that the creditors provide 85 cents for each dollar provided by
stockholders to finance the assets.

Significance and interpretation:

A ratio of 1 (or 1: 1) means that creditors and stockholders equally contribute to the assets of the
business.

A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the
portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of
assets provided by creditors is greater than the portion of assets provided by stockholders.

Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication
of greater protection to their money. But stockholders like to get benefit from the funds provided
by the creditors therefore they would like a high debt to equity ratio.

Debt equity ratios vary from industry to industry. Different norms have been developed for
different industries. A ratio that is ideal for one industry may be worrisome for another industry.
A ratio of 1: 1 is normally considered satisfactory for most of the companies.

Example 08:
The Petersen Trading Company has total liabilities of $937,500 and a debt to equity ratio of 1.25.
Calculate total stockholders’ equity of Petersen Trading Company.

Solution

Debt to equity ratio = Total liabilities/Total stockholder’s equity

Or

Total stockholder’s equity = Total liabilities/Debt to equity ratio

= $937,500/1.25
= $750,000

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Example 09: The Best Buy Inc. has declared and paid a dividend of $0.66 per share of common
stock. The company does not have any preferred stock outstanding. The information about
common stock and net income is given below:

Common stock (10,000 shares, $25 par value): $250,000

Net income: $22,000

An investor seeking for continuous dividend income wants to purchase the share of the Best Buy
Inc. For this purpose he requests you to compute the dividend payout ratio for him from the
above information.

Solution:

= $0.66/ $2.2*
= 0.3 or 30%

*Earnings per share of common stock:

$22,000/10,000 shares

Significance and Interpretation:

A low dividend payout ratio means the company is keeping a large portion of its earnings for
growth in future and a high payout ratio means the company is paying a large portion of its
earnings to its common shareholders.

Whether a payout ratio is good or bad depends on the intention of the investor. A high payout
ratio is usually preferred by those investors who purchase shares to earn regular dividend income
and a low ratio is good for those who seek appreciation in the value of common stock in future.

Companies with ample reinvestment opportunities and a high rate of return on assets usually
keep a large portion of earnings in the business and, therefore, have a low dividend payout ratio
during the first few years of establishment. Well established companies usually have a good
consistent dividend payout ratio.

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Example 10 – simple computation:
Suppose a company declares dividend at $1.70 per share. The par value of a share of the
company is $15 and the market price per share is $20. The dividend yield ratio would be
computed as follows:

= $1.70 / $20
= 0.085 or 8.5%

The dividend yield ratio is 8.5%. It means an investor would earn 8.5% on his investment in the
form of dividends if he buys the company’s common stock at current market price.

Usually, the old and well established companies are in a better position to pay a higher
percentage to the stockholders on their investment in the form of annual dividends as compared
to new ones. Consider the following example:

Example 11 – comparison of two companies:

The following information is related to PQR Company and XYZ Company for the year 2013:

Both the companies belong to same industry. PQR is an old and well established company
whereas XYZ is a new company. The historical data shows that the PQR has a stable annual
dividend distribution to stockholders.

Required: Calculate dividend yield ratio of both the companies. Which company would you
recommend for investment in shares? Explain with reasons.

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Solution:

An investor should prefer the PQR Company because its dividend yield ratio is significantly
higher than that of XYZ Company. PQR is an old and well established company with a stable
dividend distribution history. Also there are good chances of appreciation in the market value of
the stock of PQR. Because of these reasons, PQR is a more reliable and less risky company for
investment portfolio as compared to XYZ.

Significance and interpretation:

The ratio is important for those investors who purchase shares to earn dividend income. Also the
shares that earn higher dividend income can be sold in the market at higher prices that usually
results in higher profits for the investor.

Depending solely on dividend yield figure for making investment in a company may not be a
wise decision. A high dividend yield percentage may be due to a recent decrease in the market
price of stock of the company due to sever financial troubles. It may have to reduce the amount
of dividends in future that may further reduce the market value of its stock. Therefore, a
company with attractive dividend yield figure may not always be the best option.

Dividend yield ratio is only one of the several indicators that experienced investors take into
account while purchasing the shares of a company. Before making a final decision, one must
have a hard look at the historical dividend data, industry’s average dividend yield, the overall
financial strength of the company and all other available investment opportunities.

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Net income before interest and tax (Operating income):
Net income before the deduction of interest and tax expenses is frequently referred to as
operating income. Here, interest means the interest on long term loans. If company pays interest
expenses on short-term borrowings, that is deducted to arrive at operating income.

Capital employed:
Capital employed is calculated in a number of ways. Some popular methods are given below:
1. Total of fixed and current assets.
2. Total of fixed assets only.
3. Fixed assets plus working capital.
4. Total of long term funds. Long term funds include capital, Reserve and surplus etc.

In managerial accounting, the last method is usually used to calculate capital employed.

Example 12:
Fixed assets: $800,000
Current assets: $300,000
Long-term investment: $200,000
Share capital: $600,000
8% bonds: $400,000
Reserves: $200,000
Accounts payable: $100,000
Net income before interest and tax: $80,000
Required: From the above information, compute the return on capital employed ratio.

Solution:

= (80,000 / 1,000,000*)
= 0.08 or 8%
*Computation of capital employed: Fixed assets + Current assets – Current liabilities
= $800,000 + $300,000 – $100,000
= $1,000,000

Significance and Interpretation:

Return on capital employed ratio measures the efficiency with which the investment made by
shareholders and creditors is used in the business. Managers use this ratio for various financial decisions.
It is a ratio of overall profitability and a higher ratio is, therefore, better.

To see whether the business has improved its profitability or not, the ratio can be calculated for a number
of years.

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Example 13:
Following data has been extracted from the financial statements of Peter Electronics Limited.
You are required to compute the earnings per share ratio of the company for the year 2016.
Net income for the year 2016: $1,500,000

6% cumulative preferred stock outstanding on December 31, 2016: $3,000,000

$15 par value common stock outstanding on December 31, 2016: $2,376,000

The numbers of shares of both types of stock are same as they were on January 01, 2016 because
company has not issued any new shares of common or preferred stock during the year.

Solution:

From the above data, we can compute the earnings per share (EPS) ratio as follows:
= ($1,500,000 – $180,000)/ 158,400
= $8.33 per share

The EPS ratio is $8.33. It means every share of the common stock earns 8.33 dollars of net
income.

Significance and Interpretation:

The shares are normally purchased to earn dividend or sell them at a higher price in future. EPS
figure is very important for actual and potential common stockholders because the payment of
dividend and increase in the value of stock in future largely depends on the earnings of the
company. EPS is the most widely quoted and relied figure by investors. In most of the countries,
the public companies are required to report EPS figure on the income statement. It is usually
reported below the net income figure.

There is no rule of thumb to interpret earnings per share. The higher the EPS figure, the better it
is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a reliable
company to invest money. For a meaningful analysis, the analyst should calculate the EPS figure
for a number of years and also compare it with the EPS figure of other companies in the same
industry. A consistent improvement in the EPS figure year after year is the indication of
continuous improvement in the earning power of the company.

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Example 14:
Compute return on common stockholders’ equity from the following information:

Selected data from income statement for the year ended December 31, 2016:

Stockholders’ equity section of the balance sheet:

Solution:
=257,500* /1,675,000**
= 15.37%

*Net income available for common stockholders:

=$329,500 – $72,000
=$257,500

**Average common stockholders’ equity:

=[($2,550,000 +$2,400,000) / 2] – [($800,000 + $800,000) / 2]
=$2,475,000 – $800,000
=$1,675,000

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Example 15:
The following data has been extracted from the income statement and balance sheet of PQR
limited:

Data extracted from income statement for the year ended December 31, 2016:

Data extracted from balance sheets as at December 31, 2015 and 2016:

Required: Compute return on shareholders’ investment/return on total equity ratio

Solution:
= (329,500 / 2,475,000*) × 100
= 13.31%

*Average stockholders’ equity:

= (2,400,000 + 2,550,000) / 2
= 2,475,000

The return on shareholders’ investment or return on equity (ROE) ratio of PQR limited is
13.31%. It means for every $100 invested by shareholders’, the company earns $13.31 after
interest and tax.

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Significance and Interpretation:

Return on total equity (ROE) is used to measure the overall profitability of the company from
preference and common stockholders’ point of view. The ratio also indicates the efficiency of the
management in using the resources of the business.

Higher ratio means higher return on shareholders’ investment and a lower ratio indicates
otherwise. Investors always search for the highest return on their investment and a company that
has higher ROE ratio than others in the industry attracts more investors.

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Example 16:
The following information has been extracted from the income statement of Beta limited:
 Net sales: $750,000
 Cost of goods sold: $487,500
 Administrative expenses: $30,000
 Sales expenses: $45,000

Required: Compute the cost of goods sold ratio, administrative expenses ratio and sales
expenses ratio.

Solution:

1. Cost of goods sold ratio:

(Cost of goods sold /Net sales ) × 100
($487,500 / $750,000) × 100
65%
The cost of goods sold is 65% of net sales.

2. Administrative expenses ratio:

(Administrative expenses /Net sales) × 100
(30,000 / 750,000) × 100
4%
The administrative expenses are 4% of net sales.

3. Selling expenses ratio:

(Selling expenses /Net sales) × 100
(45,000 / 750,000) × 100
6%
The selling expenses are 6% of net sales.

Significance and Interpretation:

Expense ratio shows what percentage of sales is an individual expense or a group of expenses. A
lower ratio means more profitability and a higher ratio means less profitability.

Analyst must be careful while interpreting expense to sales ratio. Some expenses vary with the
change in sales (i.e. variable expenses). The ratio for such expenses normally does not change
significantly as the sales volume increases or decreases. For fixed expenses (rent of building,
fixed salaries etc.), the ratio changes significantly as the sales volume changes. The ratio is
helpful in controlling and estimating future expenses.

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Example 17:

The selected data from the records of Good Luck limited is given below:
Net sales: $200,000
Cost of goods sold: $120,000
Administrative expenses: $20,000
Selling expense: $20,000
Interest charges: $10,000

Required: Compute operating ratio for Good Luck limited from the above data.

Solution:
= (160,000* / 200,000) × 100
= 80%

The operating profit ratio is 80%. It means 80% of the sales revenue would be used to cover cost
of goods sold and operating expenses of Good Luck limited.

*Computation of operating cost:

Cost of goods sold + Administrative expenses + Selling expenses
= $120,000 + $20,000 + $20,000
= $160,000

Notice that the interest charges have not been included because they are not operating expenses.

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Example 18:

The market price of an ordinary share of a company is $50. The earnings per share is $5.
Compute price earnings ratio.

Solution:

=$50 / $5
= 10

The price earnings ratio of the company is 10. It means the earnings per share of the company is
covered 10 times by the market price of its share. In other words, $1 of earnings has a market
value of $10.

Use of P/E ratio:

P/E ratio is a very useful tool for financial forecasting. It gives information about the amount that
the investors are willing to invest in the company to earn $1.

It also helps in knowing whether the market price of share is reasonable or not. For example, the
market price of a share of XY Limited is $60 and the earnings per share is $10. The price
earnings ratio of similar companies in the same industry is 8. It means the market value of a
share of XY Limited should be $80 (i.e., 8 × $10). The market value of XY Limited is, therefore,
undervalued by $20. If the P/E ratio of similar companies is $4, the market value of a share of
XY Limited should have been $40 ($4 × $10), thus the share is overvalued by $20.

A higher P/E ratio is the indication of strong position of the company in the market and a fall in
ratio should be investigated.

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Example 19:

The following data relates to a small trading company. Compute the gross profit ratio (GP ratio)
of the company.
Gross sales: $1,000,000
Sales returns: $90,000
Cost of goods sold: $675,000

Solution:

With the help of above information, we can compute the gross profit ratio as follows:
= (235,000** / 910,000*)
= 0.2582 or 25.82%

*Net sales = Gross sales – Sales returns

= $1,000,000 – $10,000
= $910,000

**Gross profit = Net sales – Cost of goods sold

= $910,000 – $675,000
= $235,000

The GP ratio is 25.82%. It means the company may reduce the selling price of its products by
25.82% without incurring any loss.

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Example 20:

The following data has been extracted from income statement of Albari Corporation.
Gross sales: $210,000
Returns inwards: $10,000
Net profit before tax: $50,000
Income tax: 10%

Required: Compute net profit ratio of Albari Corporation using above information.

Solution:

= ($45,000* / 200,000**)
= 0.225 or 22.5%

*Net profit after tax:

= $50,000 – ($50,000 × 0.1)
= $45,000

** Net sales:
= $210,000 – $10,000
= $200,000

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Example 21:

X and Y are two independent companies that manufacture office furniture and distribute it to the
sellers as well as customers in various regions of USA. The selected data for both the companies
is give below:

Net sales during the year

X: $73,500
Y: $94,000

Net fixed assets at 1 January 2014

X: $22,500
Y: $20,000

Net fixed assets at 31 December 2014

X: $24,000
Y: $21,500

Required:

1. Calculate fixed assets turnover ratio for both the companies.

2. Can we compare the ratio of company X with that of company Y? If yes, which company
is more efficient in using its fixed assets?

Solution:

(1). Calculation of fixed assets turnover ratio:

Company X:
73,500/23,250*
3.16

Company Y:
94,000/20,750*
4.53

*Average fixed assets:

X: (22,500 + 24,000)/2
Y: (20,000 + 21,500)/2

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(2). Comparison of two companies:

The ratio of company X can be compared with that of company Y because both the companies
belong to same industry. Generally speaking the comparability of ratios is more useful when the
companies in question are in the same industry.

Company Y generates sales revenue of $4.53 for each dollar invested in fixed assets whereas
company X generates sales revenue of $3.16 for each dollar invested in fixed assets. Company Y
is therefore more efficient than company X in using the fixed assets.

Significance and interpretation:

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a low
ratio means inefficient or under-utilization of fixed assets. The usefulness of this ratio can be
increased by comparing it with the ratio of other companies, industry standards and past years.

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Example 22:

The following information has been extracted from Exide Company:

 Net sales: $300,000

 Current assets on January 1, 2016: $240,000
 Current assets on December 31, 2016: $280,000
 Current liabilities on January 1, 2016: $140,000
 Current liabilities on December 31, 2016: $100,000

Required: Compute working capital turnover ratio of Exide from the above information.

Solution:
= $300,000/$140,000*
= 2.14

*Average working capital:

[($240,000 – $140,000) + ($280,000 – $100,000)]/2

The working capital turnover ratio of Exide Company is 2.14. It means each dollar invested in
working capital has contributed $2.14 towards total sales revenue.

Interpretation:

Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient
utilization of working capital during the period. The ratio should be compared with the previous
years’ ratio, competitors’ or industry’s average ratio to have a meaningful idea of the company’s
efficiency in using its working capital.

The working capital turnover ratio should be carefully interpreted because a very high ratio may
also be a sign of insufficient quantity of working capital in the business.

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*Average daily credit purchases = Credit purchases/Number of working days in a year

Any of the above formulas may be used to compute average payment period. If credit purchases
are unknown, the total purchases may be used.

Example 23:

Metro trading company makes most of its purchases on credit. The extracted data for the year
2012 is given below:
 Total purchases: $570,000
 Cash purchases: $150,000
 Accounts payable at the start of the year: $65,000
 Accounts payable at the end of the year: $40,000
 Notes payable at the start of the year: $20,000
 Notes payable at the end of the year: $15,000

Required: Calculate average payment period from the above data assuming 360 days in a year.

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Solution:

When complete information about credit purchases and opening and closing balances of accounts
payable is given, the proper method to compute average payment period is to compute ratio first
and then divide the number of working days in a year by accounts payable turnover ratio.

= $420,000* / $70,000**
= 6 times

Average payment period = 360 days /6 times

= 60 days

*Computation of net credit purchases:

= $570,000 – $150,000
= $420,000

**Computation of average accounts payable:

= [(A/R opening + N/R opening) + (A/R closing + N/R closing)] / 2
= [($65,000 + $20,000) + ($40,000 + $15,000)] / 2
= $70,000

The average payment period of Metro trading company is 60 days. It means, on average, the
company takes 60 days to pay its creditors.

Significance and interpretation:

A shorter payment period indicates prompt payments to creditors. Like accounts payable
turnover ratio, average payment period also indicates the creditworthiness of the company. But a
very short payment period may be an indication that the company is not taking full advantage of
the credit terms allowed by suppliers.

Managers try to make payments promptly to avail the discount offered by suppliers. Where the
discount is available for early payment, the amount of discount should be compared with the
benefit of the length of the credit period allowed by suppliers.

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Example 24:

P&G trading company has good relations with suppliers and makes all the purchases on credit.
The following data has been extracted from the financial statements of P&G for the year 2012
and 2011:

 Purchases during 2012: $220,000

 Purchases returns during 2012: $20,000
 Accounts payable on 31 December, 2011: $40,000
 Accounts payable on 31 December, 2012: $20,000
 Notes payable on 31 December, 2011: $8,000
 Notes payable on 31 December, 2012: $12,000

Required: Compute accounts payable turnover ratio (creditors’ velocity).

Solution:

= $200,000* / $40,000**
= 5 times

It means, on average, P&G Company pays its creditors 5 times in a year.

* $220,000 – $20,000
** [($40,000 + $8,000) + ($20,000 + $12,000)] / 2

Significance and Interpretation:

Accounts payable turnover ratio indicates the creditworthiness of the company. A high ratio
means prompt payment to suppliers for the goods purchased on credit and a low ratio may be a
sign of delayed payment.

Accounts payable turnover ratio also depends on the credit terms allowed by suppliers.
Companies who enjoy longer credit periods allowed by creditors usually have low ratio as
compared to others.

A high ratio (prompt payment) is desirable but company should always avail the credit facility
allowed by the suppliers.

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Inventory turnover ratio = Sales / Inventory

Example 25:

Compute the inventory turnover ratio and average selling period from the following data of a
trading company:
 Sales: $75,000
 Gross profit: $35,000
 Opening inventory: $9,000
 Closing inventory: $7,000

Solution:
$40,000* / $8,000**
5 times

Computation of cost of goods sold and average inventory:

*$75,000 – $35,000 = $40,000
** ($9,000 + $7,000) / 2

Average selling period is computed by dividing 365 by inventory turnover ratio:

365 days / 5 times
73 days

The company will take 73 days to sell average inventory.

Example 26:
The ITM trading company provides you the following data for the year 2016:
 Inventory turnover ratio: 12 times
 Opening inventory at cost: $36,000
 Closing inventory at cost: $54,000
Calculate cost of goods sold for the year 2016.

Solution
Inventory turnover ratio = Cost of goods sold/Average inventory at cost
12 times = Cost of goods sold/$45,000*

Cost of goods sold = $45,000 × 12 times

= $540,000

*($36,000 + $54,000)/2

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Example 27:
The following data has been taken from the financial statements of TATA industries:
 Gross sales: $65000
 Sales returns: $2,500
 Assets at the beginning of the year: $78,000
 Assets at the end of the year: $72,000

Required: Compute assets turnover ratio for the TATA industries.

Solution:
$62,500* / $75,000**
0.83

*65,000 – 2,500
** (78,000 + 72,000)/2

Assets turnover ratio of TATA industries is 0.83. It means every dollar invested in the assets of
TATA industries produces $0.83 of sales.

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Example 28
Following data have been extracted from the books of accounts of PQR Ltd.
 Total sales: $176,000
 Cash sales: $77,000
 Accounts receivables – (closing): $8,000
 Notes receivables – (closing): $3,000

Required: Compute average collection period for PQR Ltd.

Solution
360* /9**
40 days

On average, the PQR limited have to wait for 40 days before the receivables are collected.
*Assumed number of working days in a year.
**Receivables turnover ratio has been calculated as follows:
Net credit sales / Receivables + Notes receivables
= $99,000 / $8,000 + $3,000
= $99,000 /$11,000
= 9 times

(The denominator consists of closing balances of accounts receivable and notes receivable
because opening balances of these accounts are unknown and the average cannot be worked out)
Computation of credit sales:
= $176,000 – $77,000
= $99,000

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Example 29:
The data of a trading company is given below:
Total sales $5,500,000
Cash sales $2,500,000
Accounts receivables – opening $400,000
Accounts receivables – closing $250,000
Notes receivables – opening $150,000
Notes receivables – closing $200,000

Required: How may times (on average) company collects accounts receivables?

Hint: Compute accounts receivable/debtors turnover ratio.

Solution:

= $3,000,000* / $500,000**
6 times

On average, the company collects its receivables 6 times a year.

* Credit sales:
$5,500,000 – $2,500,000 = $3,000,000

**Average tread receivables:

(400,000+250,000+150,000+200,000)/2 = 500,000

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Example 30:

Suppose a company generated $55,000 cash from operations during the last year. The current
liabilities at the beginning and at the end of the year were $45,000 and $60,000 respectively. The
current cash debt coverage ratio would be computed as follows:

$55,000 / $52,500*
1.05

Or

1.05: 1

*($45,000 + $60,000)/2

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Example 31:
Following are the current assets and current liabilities of a trading company:
Current assets: Current liabilities:
 Cash and Bank: $5,000  Accounts payable: $15,000
 Marketable securities: $18,000  Accrued payable: $5,000
 Accounts receivables, net: $8,000  Notes payable: $8,000
 Inventories: $10,000
 Prepaid expenses: $500
Required: Compute current ratio, quick ratio and absolute liquid ratio from the above data.

Solution

(1). Current ratio:

Current assets/Current liabilities
= $41,500 / $28,000
= 1.48
Or
1.48: 1

(2). Liquid ratio:

Liquid assets/Current liabilities
= $31,000* / $28,000
= 1.1
Or
=1.1: 1

(3). Absolute liquid ratio:

Absolute liquid assets/Current liabilities
= $23,000** / $28,000
= 0.82
Or
0.82: 1
*Liquid assets: $5,000 + $18,000 + $8,000 = $31,000
**Absolute liquid assets: $5,000 + $18,000 = $23,000

The reason of computing absolute liquid ratio is to eliminate accounts receivables from the list of
liquid assets because there may be some doubt about their quick collection. This ratio is useful
only when used in conjunction with current ratio and quick ratio. An absolute liquid ratio of
0.5:1 is considered ideal for most of the companies.

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Example 32:
The following are the current assets and current liabilities of PQR Limited:

Current assets:
 Cash: $2,400
 Accounts receivable: $12,000
 Inventory: $16,000
 Prepaid expenses: $600

Current liabilities:
 Accounts payable: $11,600
 Accrued parables: $1,800
 Notes payable: $600

Required: Calculate quick ratio of PQR Limited.

Solution

= 14,400*/14,000**
= 1.03
(Rounded to two decimal places)

*Liquid assets:

= (Total current assets) – (Inventories + Prepaid expenses)

=$31,000 – ($16,000 + $600)
= $31,000 – $16,600
= $14,400

** Current liabilities:

= $11,600 + $1,800 + $600

= $14,000

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Significance and Interpretation

Quick ratio is considered a more reliable test of short-term solvency than current ratio because it
shows the ability of the business to pay short term debts immediately.

Inventories and prepaid expenses are excluded from current assets for the purpose of computing
quick ratio because inventories may take long period of time to be converted into cash and
prepaid expenses cannot be used to pay current liabilities.

Generally, a quick ratio of 1:1 is considered satisfactory. Like current ratio, this ratio should also
be interpreted carefully. Having a quick ratio of 1:1 or higher does not mean that the company
has a strong liquidity position because a company may have high quick ratio but slow paying
debtors. On the other hand, a company with low quick ratio may have fast moving inventories.
The analyst, therefore, must have a hard look on the nature of individual assets.

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Examples of current assets: Examples of current liabilities:
 Cash  Accounts payable / creditors
 Marketable securities  Accrued payable
 Accounts receivables / debtors  Short term bonds payable
 Inventories / stock
 Prepaid expenses

Example 33:

On December 31, 2016, the balance sheet of Marshal Company shows the total current assets of
$1,100,000 and the total current liabilities of $400,000. You are required to compute current ratio
of the company.

Solution

Current ratio = Current assets/Current liabilities

= $1,100,000/$400,000
= 2.75 times

The current ratio is 2.75 which mean the company’s currents assets are 2.75 times more than its
current liabilities.

Example 34:
The following data has been extracted from the financial statements of two companies –
company A and company B.

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Example 35:

The T & D Company’s current ratio is 2.5: 1 for the most recent period. If total current assets of
the company are $7,500,000, what are total current liabilities?

Solution

Current ratio = Current assets/Current liabilities

2.5/1 = $7,500,000/Current liabilities
2.5 × Current liabilities = $7,500,000
Current liabilities = $7,500,000/2.5
Current liabilities = $3,000,000

Example 36:
If current ratio is 1.5 and total current liabilities are $500,000, what are total current assets?

Solution

Current ratio = Current assets/Current liabilities

1.5/1 = Current assets/$500,000

Current assets = 1.5 × $500,000

Current assets = $750,000

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