LEYTE COLLEGES

Tacloban City

MODULE
IN
FINANCIAL
MANAGEMENT 1

Prepared by:
JULIANA MAE TONIDO
BSBA – FM 2

Submitted to:
MR. JAIME CATINDOY
Instructor
CHAPTER 4

Financial Ratio and Their Implication

To Management

Objectives:
Upon finishing this session, the learner is expected to:

1. Explain fully what a financial ratio is;

2. Explain fully the objective of financial ratio analyses;
3. Explain fully and distinguish the limitations of financial ratio analyses; and
4. Perform the steps in doing financial ratio analysis, interpretation, conclusions, and
draw the implication based on the results of the applied ratios.

Lesson Proper:

In this chapter, we shall continue analyzing, using financial ratios as a tool.

Ratios present relationships between two variables. Financial ratios, therefore,
refer to the relationship between financial statement items or accounts expressed in
mathematical fashion.

In using these ratios, your task is to interpret them as favorable or unfavorable.

To do so, you should follow some standards that would determine the favorableness or
unfavorableness of the outcome. Some of the standard ratios used are based on:

1. Company budget for the same period:

2. Those used by the industry to which firm belongs;
3. Those used by the firm’s successful competitors;
4. Those used by the firm’s using prior periods; and
5. Those used by the analyst in the past.

Industry ratios are averages developed by a group of experts involved in

research. These empirically-based ratios are used as standards in financial statement
analysis. Industries have their own peculiarities; hence experts developed ratios that are
suitable for that industry. Since this task is too tedious, analysts resort to using ratios
competitors which are readily available.

There should be consistency in the computation as well as usage of ratios to

ensure comparability between results and prevent their misinterpretations. Financial
ratios are subject to limitations. Results from financial ratio analysis are indicators of a
firm’s weaknesses or strenghts but are not in themeselves, good or bad. This is
understandable since the ratios spring forth from financial statement, which are subject to
limitations.

Results derived from the computation of ratios could be presented as a

percentage (%), a fraction (1/4), a peso amount (P25.50), or a relative ratio (2:1).
IILUSTRATIVE EXAMPLE

Let us use the figures of Riel Corporation in Chapter 3 as example.

Assume further that Riel Corporation is a leading department store of fashionable clothes
and apparels with five strategic branches located in the metro.

In this example, provided is the computation of the ratios for the current year.

Riel Corporation
Comparative Statement of Financial Position
December 31, 2025 and 2024

2025 2024
ASSETS
Current Assets
Cash & Cash Equivalent 106,789 102,375
Trade & Other Receivables 327,611 277,467
Inventory 334,863 297,654
Prepaid Expenses 101,565 114,813
Total Current Assets 870,828 792,309
Noncurrent Assets
Property, Plant, & Equipment
Intangibles 135,754 166,481
Total Noncurrent Assets 7,500 7,500
TOTAL ASSETS 143,254 173,981
1,014,082 966,290
LIABILITIES AND SHARE HOLDERS’ EQUITY
Current Liabilities
Trade & Other Payables
Unearned Revenues 238,000 208,703
Notes Payable - current 107,508 82,456
Total Current Liabilities 45,000 45,000
Noncurrent Liabilities 390,508 336,159
Notes Payable - noncurrent
Total Liabilities 208,422 253,500
Shareholders’ Equity 598,930 589,659
Preference Shares
P100 par
Ordinary Shares, P1 par
Premium on Ordinary Shares 105,000 105,000
Total Paid-in-Capital 15,000 15,000
135,000 135,000
Retained Earnings 255,000 255,000
Total Shareholders’ Equity
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY 160,152 121,631
Total Shareholders’ Equity 415,152 376,631
TOTAL LIABLITIES & SHAREHOLDERS’ EQUITY 1,014,082 966,290
 Riel Corporation
Comparative Statement of Financial Position
December 31, 2025 and 2024

2025 2024
Sales P3,007,887 P2,732,712
Less: Cost of good sold 2,208,520 1,964,865
Gross Profit 799,367 767,847
Less: Selling Expenses 372,000 345,000
Administrative Expenses 207,000 213,000
Total Operating Expenses 579,000 558,000
Operating Income 220,367 209,847
Less: Interest Expense 41,860 43,905
Net Income before taxes 178,501 165,942
Less: Income Tax 62,477 58,080
Net Income after taxes P116,030 P107,862

In doing the analysis we shall cover the company status in terms of:

I. Liquidity/short-term solvency – pertains to the firm’s ability to pay any immediate and
incoming cash disbursement (payment of payable and operating cost and expenses).
II. Assets Utilization liquidity analysis – measures how often is the turnover of accounts
receivable, inventory, and long-term assets. Stated differently, we measure the liquidity of
assets, namely: accounts receivable, and long-term assets. Along with this, we also measure
how efficient is management uses these assets.
III. Debt-utilization (leverage) ratios – estimates the overall debts status of the firm in light of
its assets base and earning power. We measure the degree of the company financing in
terms of borrowing and investment or equity. We also measure the company’s ability to pay
interest and other fixed charges such as rent and payment of investment funds like singking
funds, redemptions, pensions, etc.
IV. Profitability ratios – measures the firm’s capacity to earn sufficient return on sales, total
assets, and owners’investment.

Solutions:

Liquidity/Short-term Solvency
1. Current Ratio

Current Assets of P870,828

(2025) = = 2.23:1 or 223%
Current Liabilities of P390,508
Current ratio of 2.23:1 can be interpreted
to mean that for every P1 of current liability, the company has P2.23 current assets to pay it.
This results may at times to be considered as favorable satisfactory. It indicates that Riel is
 able to pay their current maturing debts, with P1.23 to spare for every P1 of liability they
have.

It is important to remember that no single current ratio is applicable or

appropriate for all businesses. Others may consider a ratio of 1:1 as satisfactory. A high
current ratio does not necessarily mean that the company is able to meet current maturing
debts because the firm’s current assets is composed mainly of inventories. Inventory is
considered as a slow- moving asset in terms of its convertability into cash.

Another assets that some analyst do not use in the computation of the current
ratio is prepaid expenses. The reason is because they are not sources of cash.
A current ratio with a significant amount of prepaid expenses may not necessarily mean that
the firm is capable of paying current maturing obligations.

2. Upward and Downward Movement of Current Ratio

Movement in current ratio components give rise to changes in the current ratio.
Ponder on the following statements and experiment using the figures of Riel Corporation:

a. Increase in current asets or decrease in current liabilisties increases the current ratio.

Components Previous New current ratio

current ratio
Total current assets P50,000 P10,000 P60,000
Total current P25,00 P25,000
liabilities
Current ratio: 2:1 2.4:1 increase

Components Previous Increase New current ratio

current ratio (decrease)
Total current assets P50,000 P50,000
Total current P25,00 P10,000 P15,000
liabilities
Current ratio: 2:1 3.3:1 increase

Components Previous New current ratio

current ratio
Total current assets P50,000 P10,000 P60,000
Total current liabilities P50,00 P10,000 P60,000
Current ratio: 1:1 1:1 no effect/same
ratio
b. If the previous current ratio is 1:1 and there is an increase or decrease of the same
amount on both the total current assets and total current liabilities, it shall have no
effect on the new current ratio or the new current ratio will be the same as the previous.
To prove this, see the example below.
 c. If the previous current ratio is positive (current assets > current liabilities), there is
an increase by the same amount in both total current assets and total current
liabilities, the ratio shall decrease and vice-versa. The opposite will occur if the
previous current ratio is negative (current liabilities > current assets).

Components Previous current New current ratio

ratio
Total current assets P50,000 P10,000 P60,000
Total current liabilities P25,00 P10,000 P35,000
Current ratio: 2:1 positive 1.71:1 decrease

Components Previous current Increase New current ratio

ratio (decrease)
Total current assets P25,000 P10,000 P35,000
Total current liabilities P50,00 P10,000 P60,000
Current ratio: 0.5:1 negative 0.58:1 increase

3. Acid Test Radio/quick ratio/liquidity ratio

= 1.11:1 or 1.11% (2024)

(2024) =

The quick ratio is a stricter test of liquidity. This could be interpreted that for every P1
liability, the firm has p1.11 of current assets to pay it. As you can see, Riel is not as liquid
as we pictured it to be when the current ratio was used. As a general rule, the higher the
quick ratio, the more liquid the firm is and thus, can pay its current maturing debts.

Asset Utilization Liquidity Analysis

1. For Accounts Receivable

Account Receivable Turnover

Net Sales P3, 007, 887

(2025) =  = 9.94 times
Average Accounts Receivable of P227, 467 +P327,611

2
Note: for the 2024 receivable turnover you may use the ending inventory of 2014 as the
average inventory.

Days’ Sales in Average Receivables or Average Collection Period

 365 days
(2025)=  = 36.7 days
Receivable turnover of 9.94 times

This ratio is used to measure the liquidity of the firm’s accounts receivable. The
result of 9.94 times could be interpreted to mean that the firm is able to collect all their
receivables 9.94 times in a year. A high turnover rate means that receivables are
collected in a short period of time. In Riel Corporation’s case, it is able to collect the
average receivables every 37 days or approximately every month. This has great
bearing on a management since a high receivable turnover speeds up its conversion to
cash and thus, management can use it further to enhance company operations and
ultimately, increase company profits.

High receivable turnover rate does not automatically mean good or efficient
collection of the company. The high turnover rate could be caused by any of the
following:

a. Price Level Changes

b. Change in Sales terms
c. Special sales promotions
d. Strikes and plant shutdown during the previous period
e. Higher cash sales
f. (Turnover was) computed when most receivables are collected

2. For Inventory
Inventory Turnover Ratio

The inventory turnover rate pertains to the number of times the average
inventory is sold (finish goods and merchandise), used (raw materials), or
processed(work-in-process). The following formula are adapted depending on the
nature of the inventory being assessed:

Raw Materials Used

Raw Materials
Inventory turnover
= 
Average Raw Materials Inventory

Cost of Goods Manufactured

= Work-in-Process 
Inventory turnover
Average Work in Process Inventory

Cost Goods Sold

Finished Goods
Inventory turnover= 
Average Finished Goods Inventory
 Finished Goods
Cost of Goods Sold
Inventory turnover= 
Average Merchandise Inventory

Beginning Inventory + Ending Inventory

Average Inventory
= 
2

In our example, we used Merchandise Inventory; hence, the turnover rate is computed
as;

Cost of Goods Sold of P2, 208, 520

(2025)= 
P297, 654 + P334, 863
Average Inventory of 
2

The inventory turnover indicates the company’s efficiency in managing and disposing
inventory. As a general rule, the higher the turnover rate, the better. However, this is not
always the case because a higher turnover rate may also indicate that the firm is
underinvesting in their inventory or suffering lost orders. It may also mean inventory
shortages. On the other hand, a low inventory turnover rate may indicate that the firm has too
much inventory in their warehouse or is harboring too much absolute inventory. Low
inventory turnover may also mean that the company has slow moving, or worse, inferior
inventory stock, Lastly, it may indicate slow and low sales of the firm for the period.

Again it is important to mention that financial ratios, including inventory turnover rate
vary, depending on the industry the firm belongs to. Firms that are involved in highly
perishable product like vegetables, fresh meat, and other agricultural products do have
relatively high inventory turnover. On the contrary, firms selling wines, jewelry, or automobile
have relatively low inventory turnover rates but higher profit yields.

For purpose of providing an interpretation for Riel Corporation, the result has a
relatively slight unfavorable inventory turnover. A dress store like Riel should be able to
dispose of their inventory quicker, since fashion is highly dynamic and the turnover of new
clothes are high; a higher turnover for Riel would be more appropriate. The management
should recommend and come up with strategies on improving the inventory turnover ratio.

Number of days in Inventory or Average Sale Period

365 days
(2025) =  = 52.30 days
Inventory Turnover of 6.98 times
 The number of days in inventory indicates the number of days the entire inventory is
sold. As a general rule, the higher the result, the better. This indicates that since inventories are
sold out quickly, funds used for the inventories are quickly converted to cash, and ultimately
translated to more earnings. Riel’s days in inventory of 52.30 days can be still improved. It
would be better if management can dispose of their inventory in shorter number of days.

3. Property, Plant, and Equipment (PPE) or Fixed Asset Turnover

Net Sales of P3, 007, 887

(2025) =  = 3.04:1 or 304%
Average Total Assets of P1, 014, 082 + 966,290

This ratio presents the company’s efficiency in utilizing their total assets to generate
revenue. Low turnover rate means that there is slow or low sales generation or that there is
too high investment in assets. Looking at Riel’s asset turnover rate (3.04:1), we can interpret
that for every P1 asset of the company, P3.04 of sales revenue is generated. Based on this, we
can infer that the company instills more asset utilization policies that would further enhance
asset usage efficiency.

Debt-Utilization (Leverage) Ratios

The leverage ratios allow the analyst to ascertain how efficient the company manages
its financial obligations. Under this, you need to compare the liabilities and owners’ equity vis-
à -vis total assets or total liabilities and owners’ equity.

As previously mentioned in Chapter 3, the owners’ equity is consider as the margin of

safety by the creditors. This is because the owners’ equity is the amount that can absorb any
decline in asset. In other words, in case the assets of the company decline, the owners’ equity is
the amount that can be used to pay the creditors. In Riel corporation, the total asset may
decline by P415, 152 (amount of stockholders’ equity) or P598, 930 and the company will still
be able to pay its creditors

The following ratios may be used in the analyses:

1. Debt to Equity Ratio

Total Liabilities of P598, 930

(2025) =  = 1.44:1 or 144%
Total Stockholders’ Equity of P415, 152

The use of borrowed funds carrying out the firm’s operation is called trade on equity.
This means that the firm is willing to borrow money and pay fixed interest charges from the
loan. The borrowed money will be used to increase volume of operation and ultimately earn
more profit. This is an example of financial leverage

When a firm borrows fund to be used in the business, the total assets (cash) and total
liabilities (bank loan) of the company increase however, the owners’ equity remains the same.
If profits increase, the trading on equity (use of borrowed money) would increase the
debt/equity ratio and rate of return on owners’ equity.

The debt/equity ratios gauge the amount of risks involving the firm’s capital structure
in so far as the relationship of funds provided by the creditors (liabilities) and owners are
concerned.

Riel’s debt/equity ratio (144%) presents a high risk in the firm’s capital structure.
Management should be mindful of the efficient use of the company’s borrowings in improving
operations to ensure higher yields.

2. Debt Ratio

Total Liabilities of P598, 930

(2025) =  = 0.59:1 or 59%
Total Assets of P1, 014, 082

The ratio could be interpreted to mean that for every P1 asset of the company. P0.59
was borrowed or was provided by the creditors. It basically presents the proportion of
borrowings to total assets. Generally, as explained earlier, the higher the debt proportion, the
higher is the risk. In addition to this, the risk is higher because if the firm gets bankrupt, the
creditors must be paid first. If the assets are not sufficient to pay all the debts, the owners will
end up with nothing.

Riel’s debt ratio (59%) presents a relatively high risk on the part of the company.
Management should be mindful of the risk from borrowings. In additions to this, the ratio may
bring about some difficulty on the part of management to borrow when they need it. Low
owners’ equity structure decreases the margin of safety for creditors.

3. Number of Times Interest Earned

Net Income before interest and income tax or

Operating Income of P220, 367
(2025) ------------------------------------------------------------------------ = 5.26 times
Annual Interest Expense of P41, 860

The ratio indicates the ability of the firm to pay fixed interest charges. It gauges the
company’s ability to protect long-term creditors. Riel’s time interest earned of 5.26
times indicate that the firm is very much capable of paying its fixed interest charges
from its operating income.

Profitability Ratios

1. Gross Profit Ratio

Gross profit of P799,367

(2025) = ---------------------------------- = P0.26 or 0.26:1 or 26%
Net sales of P3,007,88
 This presents the gross margin per peso of sales. This is used to ascertain if the
gross margin or profit is sufficient to cover the operating expenses and the firm’s
desired net income. It also gauges the firm’s ability to control production/products. The
said mark-ups must be more than adequate to cover not only the inventory related costs
but also operating expenses and achieve a desired profit for a period.

Riel’s gross profit ratio (P0.26) indicates their ability to earn more than adequate
sales revenue to cover their costs of selling the goods. However, a 26% gross profit ratio
means a 74% costs ratio. This is relatively too high. Management must come up with
more stringest cost control measures to decrease cost of sales thereby increasing the
gross margin ratio in the succeeding years.

2. Net Profit Ratio or Profit Margin

Net Profit of P116,030

(2025) = ---------------------------------- = P0.039: P1 or 3.9%
Net Sales of P3,007,887

This ratio could mean that for every P1 sales revenue, the firm has P0.39 net
income. This gauges the profitability of the firm after including all revenues and
deducting all cost and expenses, and taxes, Riel’s net profit ratio of 39% is positive.
However, management should look closely to come up with measures that would
increase revenue and decrease costs in order to ensure and achieve the profit
maximization.

3. Return on Assets (ROA)

Net Income of P116,030

(2025) = ------------------------------------------------------- = 0.12:1 or 12%
Average total assets of P1,014,082 + P966,290
-------------------------------------------------------
2

(Du Pont Method) =Net Profit of Ratio of 3.9% x Total Asset Turnover of 3.04=12%

This could mean that for every P1 asset used by the company to generate
revenue, it yielded P0.12 of net income. It gauges the profitability of the firm in the use
of the total or total liabilities and total owner’s equity.

4. Return on Equity
Net Income of P116,030
(2025) = ------------------------------------------------------- = 0.29:1 or 29%
Ave. stockholders’ equity of P415,142+P376,631
---------------------------------------------------------------
2
This could be interpreted to mean that for every P1 of invested capital by the
owners and used to generate revenue, it yielded P0.29 of net income. This ratio, just like
the ROA, is used to gauge the company’s efficiency in managing its total assets invested
and in coming up with return to shareholders.
5. Du Pont System of Analysis

A man by the name of Donald Brown, who happened to be Du Pont’s chief

financial officer, thought of the same thing. He came up with Du Pont Equation or the Du
Pont System Analysis. The Du Pont company emphasized that satisfactory return on
assets may be achieved by having high profit margins/ net profit ratio or by having a
faster assets turnover, or a good combination of both.

The model includes the following formula to compute return on equity:

Return on Assets = Profit Margin or Net Profit Ratio x Assets Turnover

Debt Ratio = Total Liabilities/Total Assets
Equity Ratio = 1 – Debt ratio

Return on Assets
Return on Equity = --------------------------
(Du Pont Method) Equity Ratio

Using the analysis fo Riel’s Corporation:

Return on Assets = 12% (Du Pont)

Debt Ratio = 59%

12%
Return on Equity = -------------------------- = 29%
1-59%
RATIO USED TO GAUGE COMPANY LIQUIDITY OR SHORT TERM- SOLVENCY
The following are the most common ratio to gauge a firm’s liquidity or short-term
solvency:

Ratio Formula Significance

Current Assets Signifies the firm’s capacity to

1. Current Ratio Current Liabilities pay or meet current financial
obligation.

Current Assets A stricter test of liquidity;

2. Quick Ratio Current Liabilities suggests the firm’s ability to
pay current financial
Quick assets Current obligations by considering
Liabilities QA= cash + trading more liquid current assets
securities + trade and other
receivables

3. Current Assets to Total Suggests the relative liquidity

assets or Working Current Assets of the total assets and shows
capital to Total assets Total Assets the proportion of current
assets to total assets

Each Current Assets Item Signifies the proportion of

4. Each current assets Total Current Assets each current asset item to
item to Total current total assets; also indicates the
assets liquidity of the current assets
and the breakdown of each
component

5. Cash Flow Liquidity Activities Gauges the firm’s ability to

Ratio Current Liabilities pay current financial
obligation by considering
Cash& cash equivalent + cash and other cash
trading securities + Cash flow equevalents
from Operating

6. Defensive Interval Current liabilities Indicate the coverage of

Ratio Cash & Cash Equivalents current liabilities
RATIO USED TO GAUGE ASSET MANAGEMENT EFFICIENCY
The following are the most common ratio to gauge a firm’s ability to efficiency manage
their assets and measure liquidity or short-term solvency:

Ratio Formula Significance

Net Sales or Net Credit Sales Signifies the number of times the
1. Receivable turnover Average Receivables average receivables are collected
during the year; also measures the
firms efficiency in collecting their
receivables

The ratio is very much related to

2. Average Colletion 365 days or 360 days accounts receivable turnover;
Period or Number of Receivable Turnover indicates the number of days the
Days in Receivables firms collects its average receivables.
It implies the efficiency of the firm in
collecting their receivable

Suggests the number of times the

Cost of Good sold average inventory was disposed of
3. Merchandise Average Merchandise during the accounting period; also
Turnover Inventory signifies over or under investment of
the firm in their inventory

Suggests the number times the

4. Finished Goods Cost of Good Sold average inventory was disposed of
Turnover Average finished Goods during the accounting period; also
Inventory signifies over or under investment of
the firm in their inventory

Signifies the number of times

5. Work-ini- Process Cost of Goods Manufactured average inventory was produced
Turnover Average Work In Process during the accounting period ; also
Inventory indicates the time taken to produce
the products

6. Raw Material Raw Materials Used Measures the number of times

Turnover Average Raw Materials average raw materials inventory was
Inventory used during the period; also
indicates the sufficiency of the raw
materials available

7. Number of Days in 365 days or 360 days Indicates the number of days by
Inventory Inventory turnover which inventories are used or sold;
implies the firm’s efficiency in
consuming or sellng inventories
 Cost of good sold+ Operating
8. Working Capital Expenses (excluding charges Signifies the pace by which working
Turnover not requiring working capital is used; also indicates the
capital) adequacy of working capital in the
OR firm’s operation
Net Sales
Average Working Capital
Cost of good sold+Operating
9. Current Assets expenses+Income taxes+ Signifies the pace by which current
Turnover Otherexpenses (Excluding assets are used; also indicates the
charges not requiring current adequacy of current assets in the
assets like depreciation and firm’s operataions
amortization expenses)
Average Current Asset

Net Credit Purchases or Net Signifies the firm’s ability to pay

10. Payable Turnover Purchases trade payables;also measures the
Average Trade & Other numbers of times the amount of
Payables or Account Payables average payables is paid during the
accounting period

11. Operating Cycle Days sales in merchandise Measure the length of time in order
(Trading Concern) inventory+ No. of days to to convert cash to inventory
collect receivables receivables and back to cash

12. Operating Cycle No. of days’ usage in raw Measures the length of time in order
(Manufacturing materials inventory+No. of to convert cash to raw materials
Concern) days’ in production inventory to work-in-proceess to
process+No of days’ sales in finished good inventory to
finished goods inventory+No receivables and back to cash
of days to collect receivables
Average Cash Balance

Cash Operating Costs Indicates the ability of the firm’s cash

13. Days Cash 365 days or 360 days to pay the average daily cash
obligations

Net Sales Indicates the firm’s ability to

14. Asset Turnover Average Total Assets efficiently manage their assets to
generate revenue

15. Property, Plant, & Net Sales Indicates the firm’s ability to
Equipment Turnover Average PPE Assets efficiently manage their PPEs to
or Fixed Asset generate revenue
Turnover
 RATIO USED TO GAUGE FIRM’S UTILIZATION OF DEBT AND COMPANY STABILITY
The following are the most common ratio to gauge a firm’s stability or long-term
solvency:

Ratio Formula Significance

Total Liabilities Measure the relationship or

1. Debt to Equity Ratio Owners’ Equity proportions of the capital
provided by the creditors to the
capital provided by owners

2. Equity to Debt Ratio Owners’ Equity Measure the margin of safety of

Total Liabilities creditors

3. Proprietary or Equity Measures the proportions of the

Ratio Owners’ Equity firm’s assets coming from its
Total Assets owner; signifies financial
stability of the firm and cautions
the creditor

Measures the proportions of the

4. Debt Ratio Total Liabilities firm’s assets coming from its
Total Assets creditor; signifies the extent of
trading on equity.

5. Fixed Assets to Total PPE or Fixed Assets (Net) Measure the proportion of the
Owners’ Equity Owner’s Equity owners’ equity used to acquire
fixed assets

6. Fixed assets to Total PPE or Fixed Assets (Net) Signifies whether the firm over
Assets Total Assets or under invested in PPE

7. Fixed- Assets to Total PPE or Fixed Assets (Net) Measure the extent covered by
Long-term Liabilities Total Long-term Liabilities the carrying value of PPE to
long-term obligation

8. Plant Turnover Net Sales Signifies the firms efficiency in

Average PPE or Fixed Assets using their PPE
(net)
Measure the carrying value of
Ordinary Shareholders’ the net assets for every ordinary
Equity share outsatnding; also
9. Book Value per Share Number of Ordinary Shares indicates the amount, which the
Outstanding shareholders can recover if the
firm sells its assets upon
liquidition or converts them into
cash at their book values
 Signifies the firm’s capacity in
10. Number of Times Net Income before Interest paying fixed interest charges;
Interest Earned and income Taxes measures the number of times
Annual Interest Charges interest charges is covered by
the firm’s operating income

11. Number of Times Net Income After Tax Measures the firm’s ability to
Preference Shares Preference Shares Dividend pay the preference
Dividend Requirement Requirement shareholders’ dividend
is Earned requirement

Net Income Before Taxes &

12. Number of Times Fixed Charges Indicates the firm’s ability to
Fixed Charges are Fixed Expenses (Rent, pay annual fixed charges.
Earned Interest, singking Fund
payments before taxes)

RATIO USED TO GAUGE FIRM’S PROFITABILITY AND RETURN TO OWNERS

The following are the most common ratios to gauge a firm’s profitability and returns to
owners.

Ratio Formula Significance

Measure the amount of net

1. Rate of Return on Net Income income per peso of sales; also
Sales or Net Profit Net Sales shows the proportion of net
Ratio or Net Profit income to the firm’s sales
Margin revenue.

2. Rate of Return to Return on Sales x Assets Measure the company’s

Total Assets turnover profitability in using their total
assets; indicates the net income
OR generated by using the firm’s
total assets; signifies
Net Income management efficiency in using
Average total Assets their assets to earn income

Net Sales Signifies management efficiency

3. Asset Turnover Average Total Assets in using their assets to generate
sales revenue

Measures the gross profit per

4. Gross Profit Ratio Gross Profit peso of sales revenue; important
Net Sales in ascertaining the adequacy of
 gross profit to meet operating
expenses plus their desired profit

5. Operating Ratio Operating Income Measure the proportion of the

Net Sales sales revenue used to cover
operating costs.

6. Cash Flow Margin Cash Flow from Operating Indicates the firm’s ability to
Activities translate sales into cash
Net Sales

7. Rate of Return on Net Income Gauges management efficiency in

Current Assets of Average Current Assets using current assets to generate
Working Capital net income

8. Rate of Return on Net Net Income Measures management efficiency

Working Capital Average net Working Capital in using net working capital to
(Current Assets – generate revenue
Current Liabilities)

Net Income Indicates the amount of return

9. Rate of Return of Average Owners’ Equity per peso of owners’ equity;
Owners’ Equity gauges management efficiency in
using its invested capital to
generate revenue

Net Income – Preference Measure the peso return on each

10. Earnings Per Share share dividend requirement ordinary share issued; signifies
No. of ordinary Shares the firm’s ability to pay dividends
Outsatnding

Market Price per Share Indicates the relationship

11. Price – Earning Ratio Earnings Per Share between the market price of
ordinary shares and the earnings
of each ordinary share

12. Earning- Price Ratio Earning Per Share Measure the rate at which the
or Capitalization Rate Market Price per Share share market is capitalizing the
value of current earnings

Dividends Paid or Declared Indicates the earnings distributed

13. Dividends Per Share Ordinary Shares Outstanding to the owners on a per share
basis

Measures the percentage of the

14. Payout Ratio Or Dividends per Share company ‘s earnings paid to
Dividends Payout Earnings per Share owners
 Measures the probability of
15. Retained Earnings to Retained Earnings declaration of dividends by the
Share Capital Share Capital firm

16. Market Price to Book Market Price per Share Signifies the under or over-
Value Per Share Book Value per Share evaluation of shares

Learning Activities

I. Fill in the blanks.

1. _____________ present relationships between two variables.
2. The ______________ allow the analyst to ascertain how efficient the company manages
its financial obligations.
3. ___________ is considered as a slow- moving asset in terms of its convertibility into
cash.
4. Another asset that some analysts do not use in the computation of the current ratio
is ____________.
5. _________________, therefore, refer to the relationship between financial statement
items or accounts expressed in mathematical fashion.

II. Multiple Choice.

1. Measures how often is the turnover of accounts receivable, inventory, and long-term
assets.
a. Liquidity/short-term solvency
b. Assets Utilization liquidity analysis
c. Debt-utilization (leverage) ratios
d. Profitability ratios

2. Pertains to the firm’s ability to pay any immediate and incoming cash disbursement
a. Liquidity/short-term solvency
b. Assets Utilization liquidity analysis
c. Debt-utilization (leverage) ratios
d. Profitability ratios

3. Measures the firm’s capacity to earn sufficient return on sales, total assets, and
owners’ investment.
a. Liquidity/short-term solvency
b. Assets Utilization liquidity analysis
c. Debt-utilization (leverage) ratios
d. Profitability ratios

4. Estimates the overall debts status of the firm in light of its assets base and earning
power.
 a. Liquidity/short-term solvency
b. Assets Utilization liquidity analysis
c. Debt-utilization (leverage) ratios
d. Profitability ratios

5. Considered as a slow- moving asset in terms of its convertibility into cash.

a. Inventory
b. Assets Utilization liquidity analysis
c. Debt-utilization (leverage) ratios
d. Profitability ratios

III. Matching Type.

Column A Column B
1. A man who happened to be
Du Pont’s chief financial
officer A. Quick ratio
2. Allow the analyst to ascertain
how efficient the company B. Trade on equity
manages its financial
obligations C. Inventory turnover
3. Indicates the company’s
efficiency in managing and D. Debt-Utilization
disposing inventory.
4. The use of borrowed funds (Leverage) Ratios
carrying out the firm’s
operation is called ______. E. Donald Brown
5. A stricter test of liquidity.

IV. Enumeration
1. Enumerate the significance of Ratio Used to Gauge Company Liquidity or Short
Term- Solvency
2. They are the cause of high turnover rate
3. Enumerate the ratio of Ratio Used to Gauge Firm’s Utilization of Debt and
Company Stability

V. Discussion
1. What is financial ratio analysis?
2. What are the importance of financial ratio?