MODULE 3 BUSINESS FINANCE

FINANCIAL RATIOS

PROFITABILITY RATIOS

Measures the ability ratios measure the ability of a company to cover its expenses from the revenues generated.

A. Return on equity

B. Return on assets

C. Gross profit margin

D. Operating profit margin

E. Net profit margin

EFFICIENCY RATIOS

Other known as turnover ratios and activity ratios, are called as such a because they measure the
management’s efficiency in utilizing the company’s assets. The following efficiency ratios will be discussed in
this section:

a. Total asset turn over ratio

b. Fixed asset turn over ratio

c. Accounts receivable turnover ratio

d. Inventory turnover ratio

e. Accounts payable turnover ratio

f. Operating cycle and cash conversion cycle.

LIQUIDITY RATIOS

Liquidity refers to the ability of a company to pay maturing obligations.

a. Current ratio

b. Acid-test ratio or sometimes called quick ratio

STABILITY OR LEVERAGE RATIOS

There are so many names associated with stability ratios. These are leverage ratios, solvency ratios, and debt
ratios. In practice, they are used interchangeably.

a. Debt ratio

b. Debt-equity ratio

c. Interest coverage ratio

PROFITABILITY RATIOS

Return on equity (ROE)

Return on equity (ROE) is a profitability measure that should be of interest to the company owners, whether
they are single proprietors, partners, or shareholders. Fa company is publicly listed, this should be of interest
also to the potential stock market investors. ROE measures the amount of net income earned in relation to
equity. It is computed as follows:

ROE = (Net income + Equity) x 100%

For example

Let us use the financial statements of ADP foods company in 2019

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(Refers to exhibit 2.1 for the net income and exhibit 2.2 for alfoso’s capital or equity)

ROE = (Net income Equity) x 100%

ROE = (2,659,087+ 12,478,559) x 100% ROE = 21.31 %

RETURN ON ASSETS (ROA)

Return on assets (ROA) measures the ability of a company to generate income out of its resources. Below is
the formula for computing ROA:

ROA= (net income + total assets) x 100%

To illustrate, compute adp’s roa for 2019 (refer to exhibit 2.1 for the operating income and exhibit 2.2 for the
total assets)

Roa=(4,048,696 /22,298,020)x 100%

Roa= 18.16%

GROSS PROFIT MARGIN

the formula for computing gross profit margin is shown below:

gross profit margin = (gross profit + net sales) x 100%

gross profit margin provides information regarding the ability of a company to cover its cost of goods sold
from its sales. To illustrate, compute the gross profit margin of ADP foods company in 2019 (refer to exhibit
2.1 for the gross profit and net sales).

Gross profit margin =(10,546,355 / 52,501,085) x100%

Gross profit margin = 20.09%

If the manager of a company wants to improve its gross profit margin, two things can be done:

1. Raise price

2. Find ways to bring down production cost

OPERATING PROFIT MARGIN

Operating profit margin operating profit margin measures the amount of income generated from the core
business of a company. Operating profit is computed as the difference between gross profit and operating
expenses. The formula for computing operation profit margin is shown below: operating profit margin =
(0perating income +net sales) x 100%

in the case of the given illustrative example, ADP foods company, an analyst would be interested in finding
out how much operating income this company generates from its food business. The computation of ADP's
operating profit margin is found on the next page (refer to exhibit 2.1 for the operating income and net sales).

Operating profit margin =(4,048,696 / 52,501,085) x 100%

Operating profit margin = 7.71%

NET PROFIT MARGIN

Net profit margin measures how much net profit a company generates for every peso of net sales or revenues
that it generates. The formula for computing net profit margin is shown below:

Net profit margin = (net income + net sales) x 100% net income is the amount left after all expenses have been
deducted from net sales, including interest expense and income taxes.

To illustrate, compute the net profit margin of ADP foods company in 2019 (refer to exhibit 2.1 for the net
income and net sales).

Net profit margin = (2,659,087 +52,501,085) × 100% net profit margin= 5.06%
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EFFICIENCY RATIOS OR TURN OVER RATIOS

These efficiency ratios, also known as activity ratios, measure a company's efficiency in these ratios are critical
in understanding the operations of a company, especially in managing working capital accounts, including
accounts receivable and inventories. the accounts receivable turnover ratio. Inventory turnover ratio, and
accounts payable turnover ratio. The operating cycle, and the cash conversion cycle can be computed.

TOTAL ASSET TURN OVER RATIO

The total asset turnover ratio measures the company's ability to generate revenues for every peso of asset
invested. It is an indicator of how productive the company is in utilizing its resources the formula is shown
below:

total asset turnover ratio = net sales +total assets compute the asset turnover ratio of ADP foods company in
2019 (refer to exhibit 2.1 for the net sales and exhibit 2.2 for the total assets).

Total asset turnover ratio = 52,501,085 +22,298,020

total asset turnover ratio = 2.35

FIXED ASSET TURNOVER RATIO

If a company is heavily invested in property, plant, and equipment (PPE) or fixed assets, it pays to know how
efficient the management is with utilizing these assets. This can be applied to companies that are characterized
by high PPE, such as utility companies, e.G., Telecom companies, power generation and distribution
companies, and water distribution companies. It can also be applied to manufacturing companies. The formula
for computing fixed asset turnover ratio is shown below:

fixed asset turnover ratio = net sales + PPE

let us compute the fixed asset turnover for ADP foods company in 2019 (refer to exhibit 2.1 for the net sales
and exhibit 2.2 for the PPE).

Fixed asset turnover ratio =52,501,085+ 12,200,000 fixed asset turnover ratio = 4.30

ACCOUNTS RECEIVABLE TURN OVER RATIO

The accounts receivable turn over ratio measures the efficiency by which accounts receivable are managed. A
high accounts receivable turn over ratio means efficient and management of receivables. The formula for
accounts receivable turnover ratio is shown below.

Accounts receivable turn over ratio= net sales / gross trade accounts receivable

Compute the accounts receivable turnover ratio for adp foods company in 2019 9refer to exhibit 2.1 the for net
sales and exhibit 2.2 for the gross trade accounts receivable).

Accounts receivable turn over ratio = 52,501,085 / 2,300,000^4

Accounts receivable turnover ratio= 22.82

Average collection period = 360/22.82

Average collection period = 15.77 or 16 days

INVENTORY TURNOVER RATIO

The inventory turnover ratio measures a company's efficiency in managing its inventories. Trading and
manufacturing companies, companies dealing with highly perishable products, and those prone to
technological obsolescence must pay close attention to this ratio to minimize losses.

The formula for computing inventory turnover ratio is shown below:

inventory turnover ratio = cost of sales ÷ inventories

Compute the inventory turnover ratio of ADP foods company in 2019 (refer to exhibit 2.1 for the cost of sales
and exhibit 2.2 for the inventories).
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Inventory turnover ratio = 41,954,730 ÷ 4,849,304

inventory turnover ratio = 8.65

the inventory turnover ratio becomes more meaningful when converted into days inventories. To convert,
simply divide 360 days by the inventory turnover ratio if annual data are used. Otherwise, use 90 days if
quarterly data are used.

Days' inventories = 360 ÷ inventory turnover ratio

days' inventories = 360 ÷ 8.65

days' inventories = 41.62 or 42 days

Accounts payable turnover ratio the accounts payable turnover ratio provides information regarding the rate by
which trade payables are paid. Any operating company will prefer to have a more extended payment period for
its accounts payable, but this should be done only with the concurrence of the suppliers. The formula below
shows the computation for the accounts payable turnover ratio:

accounts payable turnover ratio = cost of sales ÷ trade accounts payable the accounts payable turnover ratio of
ADP foods company in 2019 is 8.31 computed as follows (refer to exhibit 2.1 for the cost of sales and exhibit
2.2 for the trade accounts payable):

accounts payable turnover ratio = 41,954,730 ÷ 5,050,810

accounts payable turnover ratio = 8.31

From the accounts payable turnover ratio, days' payable can be computed. For ADP foods company, days'
payable in 2019 was 43.32 days or 43 days computed as follows:

days payable = 360 ÷ accounts payable turnover ratio

days' payable = 43.32 or 43 days

OPERATING CYCLE AND CASH CONVERSION CYCLE

By adding the average collection period and days' inventories, the operating cycle can be computed. This
operating cycle covers the period from the time the merchandise is bought to the time the proceeds from the
sale are collected. Managers of companies will prefer to have a short operating cycle as compared to a long
one. A low or short operating cycle is an indication of efficient management of trade accounts receivable and
inventories.

In 2019, ADP foods company had an operating cycle of 58 days computed as follows: operating cycle = days'
inventories + days' receivable operating cycle = 42 + 16 operating cycle = 58 days

The formula is shown below: cash conversion cycle = operating cycle - days' payable for ADP foods company,
its cash conversion cycle is 15 days computed as follows: cash conversion cycle = 58 days - 43 days cash
conversion cycle = 15 days

LIQUIDITY RATIOS

CURRENT RATIOS

Current ratio= current assets / Current liabilities

To illustrate, compute the current ratio of ADP Foods Company in 2019

Current Ratio = Current assets / Current Liabilities

Current ratio = 9,262,331 / 7,819,461

Current ratio= 1.18

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In evaluating liquidity ratios such as the current ratio, attention must also be made to the quality of other
current assets which were discussed in the turnover or efficiency ratios

ACID-TEST RATIO OR QUICK RATIO

Quick ratio = (Cash+ Current accounts receivable + short term Marketable securities)/ Current Liabilities

Quick ratio is a stricter measure of a company’s Liquidity position can also be computed as follows.

Quick ratio= (Current assets – inventories)/ Current liabilities

To illustrate, compute the quick ratio of ADP Foods Company in 2019

Quick ratio = (1,062,527 +2,300,500) / 7,819,461

Quick ratio= 0.43

STABILITY OR LEVERAGE RATIOS

Stability ratios measure how much of the total assets of a company are financed by liabilities and equity,
otherwise known as capital structure.

1. Nature of business
If a company is in risky business and operating cash flows are uncertain, like mining operations, it has
to be more conservatively financed. Stable operating cash flows allow the company to pay periodic
debt amortizations
2. Stage of business development
A company that is just starting its operations may encounter difficulties borrowing from banks. Banks
generally look for the historical performance of a company in making decisions regarding loan
applications. A new company does not have that historical record.

3. Macroeconomic conditions
If macroeconomic conditions are good as measured by gross domestic product (GDP) and these good
macroeconomic conditions are expected to continue in the foreseeable future, management can take a
more aggressive stance in financing a company’s operations to take advantage of the opportunities.
4. Prospects of the industry and expected growth rates.
If the industry where a company operated has good prospects and growth rates are expected to be high.
Management can consider borrowing more to expand operations. Otherwise, if the prospects are bleak,
it is better to have low debt ratios.
5. Bond and stock market conditions
The ability of a company to raise more funds from the stock market and the bond market also depends
on how bullish players are in these markets.
6. Financial flexibility
It refers to the ability of a company to raise funds, be it the stock market or the bond market when the
need for cash arises.
7. Regulatory environment
There are heavily regulated operations such as banks regulated by the Bangko Sentral ng Pilipinas
(BSP).
8. Taxes
Interest expense provide a tax shield, while cash dividend does not provide give tax shield.
9. Management style
Some managers are aggressive, and some are conservative. Management style contributes to the kind
of capital structure a company has.
a. Debt ratio
Measures how much of the total assets are financed by liabilities
FORMULA FOR DEBT RATIO
Debt ratio= Total Liabilities / total Assets
b. debt-to-equity ratio
The debt-to-equity ratio is a variation of the debt ratio. Debt-equity-ratio of more than one means
that a company has more liabilities than stockholders’ equity. The formula for the debt-to-equity
ratio is shown below:
Debt-to-equity ratio = Total Liabilities / equity
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c. Interest coverage ratio

Provides information if a company has enough operating income to cover interest expenses
Below is the formula
Interest coverage ratio= Operating Income / Interest expense

Quality of earnings

1. Is the income coming from the core business?

2. How much of the net income translate into cash flow?

3. Is the Income stable?

Limitations of financial statement analysis

1. The financial analysis deals only with quantitative data

2. Management can take short-run actions to influence ratios

3. Different companies may use different accounting principles even if they come from the same
industry.

4. Different formulas can be used in computing financial ratios.

5. The amounts found in the financial statements are already part of history.

6. A financial ratio standing alone is useless.

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Name_______________________________________________ Date__________________ Score_________

Activity: Financial statement analysis

Answer the ff. questions in the space provided for each question.

1. Name four groups of financial ratios covered in this chapter and explain briefly.
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2. Identify five factors that will affect the capital structure of a company and explain each briefly.
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d. _______________________________________________________________________________
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3. List three limitations of financial statement analysis and explain each briefly.
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