Fundamentals of Accountancy,Business and Management 2

Financial Ratio Page 1 of 21

MODULE 8
ABM5 –FUNDAMENTALS OF
ACCOUNTANCY, BUSINESS
AND MANAGEMENT 2

Name: _____________________________________________________

Student Number: _________________

Strand: _________________

Teacher’s Name: _________________________________

Date Released:___________________ Date Submitted:___________

 Fundamentals of Accountancy, Business and Management 2
Financial Ratio Page 1 of 21

Topic: Analysis and Interpretations of Financial Statement

Financial Ratio
Welcome Notes:
WELCOME ABM STUDENTS.

1.1 define the measurement levels, namely, liquidity, solvency, stability,

WELCOME ABM STUDENTS.
and profitability

Financial Ratio

⚫ Financial Ratio it is composed of a numerator and denominator. It expresses the

relationship between specific financial statement data. The resulting ratio may be
interpreted as a percentage, a rate or proportion.

⚫ Financial ratios make use of the relationship of accounts though ratios and
percentages.

1. Liquidity

Liquidity is a company’s ability to convert its assets to cash in order to pay its liabilities
when they are due.

2. Solvency

Solvency is a key metric used to measure an enterprise’s ability to meet its debt
obligations and is used often by prospective business lenders. The solvency ratio
indicates whether a company’s cash flow is sufficient to meet its short-and long- term
liabilities. The lower a company's solvency ratio, the greater the probability that it will
default on its debt obligations.
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3. Stability

Stability is the long-term counterpart of liquidity. Stability analysis investigates how much
debt can be supported by the company and whether debt and equity are balanced. The
most common stability ratios are the Debt-to-Equity ratio and gearing.

4. Profitability

Profitability ratios are a class of financial metrics that are used to assess a business
ability to generate earnings relative to its revenue, operating costs, balance sheet
assets, and shareholders' equity over time, using data from a specific point in time.

LIQUIDITY

NAME DESCRIPTION FORMULA

Current Tests the ability of the Total Current Assets / Total Current
Ratio company to pay for its current Liabilities
obligation.

Acid Ratio A stricter test of the company’s Total Quick Assets / Total Current
or ability to pay current Liabilities
Quick Ratio obligation.
Note: To compute Quick Assets
- Inventory and prepaid assets removed inventory and prepaid
are removed from the question assets from the total value of
current assets

Working Excess of current assets after Current Assets - Current Liabilities

Capital covering the current liabilities.

- Shows the remaining amount

of current assets that can be
used in the operation.
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MANAGEMENT EFFICIENCY

NAME DESCRIPTION FORMULA

Receivable Test the efficiency of managements Net Credit / Average Accounts

Turnover collection of receivables. Receivable (Net)

Inventory Determine the efficiency of the Cost of Goods Sold / Average

Turnover company in managing. Merchandise Inventory

STABILITY

NAME DESCRIPTION FORMULA

Debt Ratio Shows proportion of all assets Total Liabilities / Total Assets
that are financed with liabilities.

Equity Ratio Shows proportion of assets from Total Equity / Total Assets
owners.

Debt to Equity Measures debt about equity. Total Liabilities / Total Equity
Ratio
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PROFITABILITY

NAME DESCRIPTION FORMULA

Gross Determines the percentage of profit Gross / Profit

Profit generated after deducting cost of
Margin goods sold.

Net Profit Determine the percentage of profit Net Profit / Net Sales
Margin after adding all income and deducting
all expenses.

Rate of Measures rate of return on resources Net Income / Average

Return on provided by owners. Ordinary Equity
Equity

4.2 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.

To illustrate the use of financial ratio, the financial statements of ABC company for the
year 2015 is presented below.
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ABC Company
Statement of Financial Position
December 2014, and 2015
Assets 2015
Current Assets
Cash 100,000.00
Accounts Receivable, Net 450,000.00
Inventory 200,000.00
Accrued Income 300,000.00
Prepaid Expenses 50,000.00
Total Current Assets 1,100,000.00
Non-Current Assets
Long Term Investment 250,000.00
Intangible Assets 500,000.00
Property, Plant and Equipment Cost 700,000.00
Total Non-Current Assets 1,450,000.00
Total Assets 2 ,550, 000. 00
Liabilities & Owner’s Equity
Current Liabilities
Accounts Payable 250,000.00
Accrued Expense 100,000.00
Unearned Income 80,000.00
Notes Payable 150,000.00
Total Current Liabilities 580,000.00
Non-Current Liabilities
Mortgage Payable 500,000.00
Total Non-Current Liabilities 500,000.00
Total Liabilities 1,080,000.00
Owner's Equity 1,470,000.00
Total Liabilities & Owner's Equity 2,550,000.00
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ABC Company
Statement of Comprehensive Income
For the Year Ended December 31, 2014 and 2015
2015
Net Sales 731,000.00
Cost of Goods Sold 363,000.00
Gross Profit 368,000.00
Administrative Expense 60,000.00
Selling Expense 40,000.00
Net Income 25,000.00

The financial ratios are computed and interpreted as follows.

Liquidity

Current Ratio

Formula: Total Current Assets / Total Current Liabilities

Computation: 1,100,000 / 580, 000

Current Ratio: 1.90:1

Interpretation: This means that the company have approximately 1.9 current assets to
pay for every 1-peso Current liability of the company.

Acid Test Ratio or Quick Ratio

Formula: Total quick assets / Total Current Liabilities

Quick Assets: Removed inventory and prepaid assets from the total value of current
assets.

Computation: 850,000 / 580,000

Quick Ratio: 1.47:1

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Interpretation: This means that even if the inventory and prepaid assets are removed
the company are still able to meet their current obligations. For every 1-peso
current liability, they have an estimated amount of 1.47 pesos to cover for it.

Working Capital

Formula: Current Assets / Current Liabilities

Computation: 1,100,000 - 580,000

Working Capital: 520,000

Interpretation: This means that the company has 270,000 pesos free current assets that
they can use for the operations of the business.

Management Efficiency

Receivable Turnover

Formula: Net Credit Sales / Average Accounts Receivable (Net)

Computation: 731,000 / 500,000

Receivable Turnover: 1.46 Times

Interpretation: The low receivable turnover indicates the efficiency of the company in
collecting their receivables. This may be because of poor credit and collection
policies.

Inventory Turnover

Formula: Cost of Goods Sold / Average Merchandise Inventory

Computation: 363,000 / 200,000

Inventory Turnover: 1.82 Times

Interpretation: the low inventory turnover indicates the inefficiency of the management in
managing inventory. This could indicate that the company is storing too much
inventory about its ability.
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Stability

Debt Ratio

Formula: Total Liabilities / Total Assets

Computation: 1,080,000 / 2,550,000

Debt Ratio: 42.35%

Interpretation: This means that 42.35% of the company’s assets are being financed by
creditors.

Equity Ratio

Formula: Total Equity / Total Assets

Computation: 1,470,000 / 2,550,000

Equity Ratio: 57.65%

Interpretation: This means that 57.65% of the company’s assets are being financed by
the company’s own capital.

Debt to Equity Ratio

Formula: Total Liabilities / Total Equity

Computation: 1,080, 000 / 1,470,000

Debt to Equity Ratio: 73.47%

Interpretation: this means that compared to the total equity, the liabilities represent
around 73.47% of the company’s capital.
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Profitability

Gross Profit Margin

Formula: Gross Profit / Net Sales

Computation: 368,000 / 731,000

Gross Profit Margin: 50.34%

Interpretation: This means after deducting cost of goods sold 50.34% of net sales is left
and is available for other expenses.

Net Profit Margin

Formula: Net Profit / Net Sales

Computation: 25,000 / 731,000

Net Profit Margin: 3.42%

Interpretation: This means that after all the income and expenses have been considered
3.42% of the net sales is left for the company.

Rate of Return Equity

Formula: Net Income / Average Equity

Computation: 25,000 / 1,470,000

Rate of Return Equity: 1.7%

Interpretation: this means that the owner was able to get returns equivalent to 1.7% of his
investment in the company based on the performance of the company this year.