Senior High School

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LEARNING ACTIVITY SHEET
Fundamentals of Accountancy Business and Management 2
Quarter 3, Week 7A

 compute and interpret financial health ratios. (ABM_FABM12- Ig-h-14)

Introduction:
In the previous lesson, you were able to compute for the profitability and
efficiency ratios of a business. While these two are the primary indicators that the
company is earning and that the company’s resources are used efficiently, the
ratios are most useful for a limited group of users only – the owners, managers,
and potential investors. These groups of users are very particular with the profit-
earning ability of a business.

How about the lenders and creditors? If you were to lend money to a
company, are these ratios enough indicators of the ability of the company to pay
its liabilities? If the company is earning income, does it really mean that it will be
able to pay its debts?

The answer to these questions is NO. Profitability and efficiency ratios are
not sufficient gauge of a company’s debt-paying ability. You should note that net
income is not all cash. There are non-cash items included in the computation of
the net income.

So how can creditors measure the financial capacity of the business to pay
its debts? The answer lies in the two remaining ratios that we will be computing –
the liquidity and solvency ratios.

Learning competency:

At the end of the lesson the learners will be able to:

K: Identify the different ratios

S: compute and interpret profitability and operational efficiency ratios
A. Appreciate the significance of financial analysis for the success of the business.

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 Read each item carefully. Choose the letter that corresponds to the correct
answer. Write the letter of your choice on your answer sheet.

1. Which group of ratios measures a firm’s ability to meet short-term

obligations?

2. A. Profitability Ratios C. Efficiency Ratios

B. Liquidity Ratios D. Solvency Ratios
All
of the following are measures of a company’s solvency, except ___________.
A. Equity Ratio C. Acid Test Ratio
3. B. Times Interest Earned D. Debt-to-Equity Ratio
Which of the following statements is INCORRECT about current ratio?
A. The higher the current ratio, the better the liquidity of the business is.
B. Current ratio is the primary measure of the liquidity of the business.
C. The quick ratio is higher than the current ratio.
D. Current ratio shows the relationship between current assets and
current liabilities.

4. The quick ratio EXCLUDES which of the following?

5. A. Accounts Receivable C. Inventory

B. Cash D. Marketable Securities
Which of the following is the formula for current ratio?

6. A. Current Ratio = Current Assets – Current Liabilities

B. Current Ratio = Current Assets ÷ Current Liabilities
C. Current Ratio = Current Liabilities ÷ Current Assets
D. Current Ratio = Current Liabilities – Current Assets
What is the main difference between liquidity and solvency ratios?
A. Liquidity ratios measure a company’s long-term ability to pay debts
while solvency ratio focuses more on short-term ones.
B. Liquidity ratios measure a company’s short-term ability to pay debts
while solvency ratio focuses more on long-term ones.
C. Liquidity ratios measure the relationship of income statement items
while solvency ratio focuses on equity items.
D. Liquidity ratios measure the relationship of equity items while
solvency ratio focuses on income statement items.

7. Which of the following ratios is not a solvency ratio?

A. Return on Equity C. Debt to Equity Ratio

B. Interest Coverage Ratio D. Equity Ratio
8. The formula for computing debt to equity ratio is ___________.
A. Total Equity ÷ Total Assets C. Total Debt ÷ Total Assets
B. Total Equity ÷ Total Debt D. Total Debt ÷ Total Equity

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 9. A debt ratio provides information about _________________.
A. the percentage of asset financed by debt
B. the percentage of equity financed by debt
C. the percentage of debt in relation to equity
D. the percentage of debt in relation to income

10.Which of the following formula defines Equity Ratio?

A. Total Debt ÷ Total Equity C. Total Debt ÷ Total Assets
B. Total Equity ÷ Total Debt D. Total Equity ÷ Total Assets

Match the financial ratio found in column A with its correct description
found in column B. Write only the letter of the correct answer on your answer
sheet.

Column A Column B
a. It measures the amount of peso earned for
1. Gross Profit Ratio every peso of capital invested by the
owners.
b. It provides information on how many days
2. Net Profit Ratio
can a business collect its AR.

c. It tells how much markup the sales have

3. Return on Equity
over the cost of goods sold.

d. It measures how much of the sales will go

4. Total Assets Turnover
to the owners.
e. This ratio measures the number of times
5. Inventory Turnover a business can collect its receivables from
customers for a given period.
f. It measures the amount of revenue
6. Accounts Receivable Turnover generated for every peso amount of asset
used in operations.
g. It measures how often the company’s
stocks is sold.

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 Lesson
Liquidity and Solvency Ratios
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To complete the primary measures of a company’s financial health and condition,
this section will discuss the two remaining categories of financial ratios: the
liquidity and solvency ratios.
Liquidity Ratios
These are ratios that measure the firm’s ability to meet its short-term
needs and pay its current obligations. These ratios are commonly used by
creditors or lenders in deciding whether to grant credit or debt to companies.
Liquidity Ratios examine the relationship of current assets and current
liabilities.

1. Current Ratio is a widely used measure of the liquidity and short

debt paying ability of businesses. Higher current ratio means a
better liquidity position for the company.

Formula:
Current Ratio = Current Assets
Current Liabilities
2. Quick Ratio is also known as the acid-test ratio. It is a modified
and stricter measure of the company’s liquidity. Quick ratio aims
to measure the company’s ability to pay its current obligations
with its most liquid assets, thus, inventories are excluded in the
computation of this ratio. The most liquid assets of the company
includes cash, accounts receivable and short-term investments.
They are often referred to as the quick assets.

Formula:
Current Assets – Inventories – Prepaid Expenses
Quick Ratio =
Current Liabilities

3. Net Working Capital measures the amount of current assets in

excess of its current liabilities. By computing the net working
capital, one would be able to see if the company has a margin of
safety which means that its current assets are sufficient to cover
its current liabilities. A positive net working capital means that the
company is doing well.

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 Formula:
Net Working Capital = Current Assets – Current Liabilities
Note: A comprehensive example of how liquidity ratios are applied to the
financial statements are found in pp 48-49 of this module.
Solvency Ratios
These are ratios which determine the company’s ability to operate as a
going concern. It is a measure of the capacity of the company to pay its long-
term debts by looking at its asset, liabilities, and equity structure. Higher
solvency ratios are indications of a more creditworthy and financially sound
business. Solvency ratios are sometimes called leverage ratios.

1. Debt-to-Equity Ratio shows the percentage of debt used by the

company to finance its asset in proportion to its equity. It
measures the company’s degree of reliance to debt as a source of
financing versus its wholly owned capital. Generally, a higher
debt-to-equity ratio is discouraged. If the debt levels are too high,
it may expose the company to a greater risk of bankruptcy during
hard times.

Formula:

Debt-to-Equity Ratio = Total Liabilities

Total Equity

2. Debt Ratio shows the percentage of total assets financed by debt.

A higher debt ratio means greater reliance on debt as source of
financing.

Formula:

Debt Ratio = Total Liabilities x 100

Total Assets

3. Equity Ratio is sometimes called the Proprietary Ratio. It

indicates the extent of capital or equity invested in the company’s
assets. Generally, a higher equity ratio is preferred.

Formula:

Equity Ratio = Total Equity x 100

Total Assets

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 4. Interest Coverage Ratio measures the degree with which the
company’s operating income is able to cover its interest expense.
Interest Coverage Ratio is also known as Times Interest Earned
Ratio.

Formula:
Interest Coverage Ratio = Operating Income or EBIT
Interest Expense

Note: A comprehensive example of how solvency ratios are applied to the

financial statements are found in pp 48-49 of this module.

Comprehensive Example of Liquidity and Solvency Ratios:

The SCI, Comparative SFP and additional information for ABM Company is
given below. Use the given data to compute for ABM Company’s liquidity and
solvency ratios.

ABM Company
Statement of Comprehensive Income
For the year ended December 31, 2019

Net Sales ₱360,000

Cost of Goods Sold 234,000
Gross Profit 126,000
Operating Expenses 48,000
Operating Income 78,000
Interest Expense 14,000
Income Before Income Taxes 64,000
Income Tax Expense 19,200
Net Income ₱44,800

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 ABM Company
Statement of Financial Position
December 31, 2019

Assets
Cash ₱57,000
Accounts Receivable 48,000
Inventories 50,000
Fixed Assets 180,000
Total Assets ₱335,000

Liabilities and Owner’s Equity

Accounts Payable ₱65,000
Long-term Liabilities 100,000
Total Liabilities 165,000
Owner’s Equity 170,000
Total Liabilities and Owner’s Equity ₱335,000

Ratio Computation Interpretation

Liquidity Ratios

For every ₱1 current

155,000 liabilities, there is ₱2.4
1. Current Ratio =2.4 :1
65,000 worth of current assets to
pay for it.
For every ₱1 current
105,000 liabilities, there is ₱1.6
2. Quick Ratio =1.6 :1
65,000 worth of quick assets to
pay for it.
If all current liabilities are
3. Net Working to be settled, the company
155,000−65,000=90,000 has still ₱90,000 worth of
Capital
current assets to continue
its operations.

Solvency Ratios

The company uses ₱0.97

worth of debt for every ₱1
1. Debt-to-Equity 165,000 equity to finance its
=0.97 :1 assets.
Ratio 170,000 Or
The debt level is 97% of
equity.

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 165,000 49% of total assets are
2. Debt Ratio x 100=49 %
335,000 financed by debt.
170,000 51% of total assets are
3. Equity Ratio =51%
335,000 financed by equity.

4. Interest Coverage 78,000 The company has 5.6

=5.6׿ times more earnings than
Ratio 14,000 its interest payments.

Given below are financial information for MBA Company.

M BA Company
Statement of Financial Position
Dec-31
2019
Assets
Cash ₱33,000
Accounts Receivable, net 22,000
Inventory 38,000
Building, net 70,000
Land 80,000
Total Assets ₱243,000

Liabilities and Owner’s Equity

Accounts Payable ₱25,000
Loans Payable, 5 years 104,000
Total Liabilities 129,000
Owner’s Equity 114,000
Total Liabilities and Owner’s Equity ₱243,000

Additional Information:

1. Gross Profit is ₱65,000Operating Expense’s total ₱38,000.

2. Interest Expense ₱10,400.

On your answer sheet, compute and interpret the company’s:

1. Current Ratio
2. Quick Ratio
3. Net Working Capital
4. Debt-to-Equity Ratio
5. Debt Ratio
6. Equity Ratio
7. Interest Coverage Ratio

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 Smell Good Co., a perfume reseller, recently concluded its first year of
operations. A potential investor, Mr. Mabango, contacted the owner, Ms. Marikit for
a possibility of venturing into the business and asked her to provide him with the
company’s liquidity and solvency ratios. Ms. Marikit, who does not have an idea of
these ratios, came to you for help. She provided you with the following information
for 2019.

1. Net Sales for the year is ₱500,000. Sales Return amounts to ₱25, 000
while Cost of Goods Sold is ₱367,500.
2. Operating Expenses totaled ₱88,700 while Interest Expense is ₱15, 200.
3. Assets are composed of the following: Cash – ₱48,600; Accounts
Receivable - ₱56,400; Inventory - ₱80,000; Prepaid Rent – ₱24,000; and
Fixed Assets – ₱275,000.
4. Accounts Payable of ₱123,000 and Loans Payable (3 years) of 180,000 are
the only liabilities.

Prepare a report using the format below for the computation and
interpretation of Smell Good Co.’s liquidity and solvency ratios. Use a separate
sheet for your analysis.

Financial Health Ratio Analysis: Smell Good Co.

Ratios Computation Interpretation

Current Ratio
Quick Ratio
Net Working Capital
Debt-to-Equity Ratio
Debt Ratio
Equity Ratio
Interest Coverage Ratio

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 Scentiments
Statement of Comprehensive Income
For the year ended December 31, 2019

Net Sales ₱150,000

Cost of Goods Sold 97,500
Gross Profit 52,500
Selling and Administrative Expenses 37,500
Operating Income 15,000
Interest Expense 3,000
Income Before Income Taxes 12,000
Income Tax Expense 2,400
Net Income ₱9,600

Scentiments
Statement of Financial Position
December 31, 2019

Assets
Cash ₱21,400
Accounts Receivable 5,700
Inventories 22,400
Prepaid Rent 9,000
Fixed Assets 75,000
Total Assets ₱133,500

Liabilities and Owner’s Equity

Accounts Payable ₱16,000
Loans Payable, 3 years 60,000
Total Liabilities 76,000
Owner’s Equity 57,500
Total Liabilities and Owner’s Equity ₱133,500

Compute and interpret the liquidity and solvency ratios of Scentiments for
the year 2019. Use a separate answer sheet.

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 POST-TEST

Liquidity Ratio

58,500
Current Ratio= =3.6:1
16,000

For every ₱1 current liabilities, there is ₱3.6 worth of current assets to pay
for it.
58,500−22400−9000
Quick Ratio= =3.6 :1
PRE-TEST 16,000
For every ₱1 current liabilities, there is ₱3.6 worth of quick assets to pay
1.B for it. pay r every ₱1 current liabilities, there is ₱1.6 fit.
2.B Net Working Capital=58,500−16,000=42,500
3C If If all current liabilities are to be settled, the company has still
₱42,500 worth of current assets to continue its operations.
4.C
5.B Solvency Ratios
6.B
7.A 76,000
Debt−¿−Equity Ratio= =1.3 :1
57,500
8.D The company uses ₱1.30 worth of debt for every ₱1 equity to finance
9.A its assets.
10.D
76,000
Debt Ratio= x 100=56.92%
133,000
56.92% of total assets are financed by debt.
57,500
Equity Ratio= x 100=43.07 %
133,500
43.07% of total assets are financed by equity.
15,000
Interest Coverage Ratio= =5
3,000
The company has 5 times more earnings than its interest payments.

X. References

(1) Valencia, et. al. Basic Accounting 3rd edition 2009-2010, Valencia
Educational Supply, 2009.
(2) Weygandt, J. et. al. Accounting Principles 2010 edition. John Wiley
and Sons.
(3) Valix, Conrado T. et. al. Financial Accounting Volume 1 2015 editions.
GIC Enterprises & Co. Inc. 2015.
(4) Jerry G Bianco LAS Fundamentals of Accountancy, Business and
Management 2
Prepared by:

SHS Teacher III

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