SAINT COLUMBAN COLLEGE

College of Business Education

Pagadian City

HANDOUT FIN-MAN 2304

FINANCIAL STATEMENTS ANALYSIS – PART 2

RATIO ANALYSIS
This is a quantitative method for gaining insight into a company’s liquidity, operational efficiency,
and profitability by examining financial statements. This is a fundamental component of equity
analysis.

Classifications of Financial Ratios

1. Profitability Ratios – is a measure of operating effectiveness. It measures the ability of
the business to recover long-term investment from money generated by its normal
operating activities.
2. Liquidity Ratios – reflect the ability of the business to accelerate its operating cycle to
meet operating obligations and payments.
3. Activity Ratios – measure the efficiency of the organization in utilizing its assets for
generating cash and revenue.
4. Solvency and Leverage Ratios – measure the ability of the business to use debt in
maximizing shareholders’ value.
5. Growth or Market Test Ratios – reflect the potential strength of the enterprise in the
marketplace. The enterprise’s market power is measured by market values of its equity
shares.

1|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
A. PROFITABILITY RATIOS
Type of Ratios Formula Definition

Measures gross profit percentage on sales to recover operating

1. Gross Profit Rate = Gross Profit / Net Sales
expenses.
2. Return on Sales = Net Profit / Net Sales Also called Profit Margin. Measures profit percentage per peso sales.
= OPAT / Average Total Assets Measures overall asset profitability; indicates how effective assets
have been employed by the management.

3. Return on Assets = (EBIT x ATR) / Average Total Assets

NOTE: OPAT = Operating Profit After Tax or EBIT minus Tax
= (Profit + Interest Expense net of Tax) / EBIT = Earnings Before Interest
Average Total Assets ATR = After Tax Rate
Measures percentage of income derived for every peso of owners’
4. Return on Equity = Net Profit / Average Shareholders’ Equity
equity.

Measures the percentage of profit derived for every peso of ordinary

equity used.
5. Return on Ordinary SHE = PAOS / Average Ordinary SHE
NOTE: PAOS = Profit Available to Ordinary Shareholders
PAOS = Profit less Preference Dividends

Measures divisional performance, determines the accounting rate of

6. Return on Segment Investment = Operating Profit / Average Segment Assets
return on every peso of investment in a project or business.
Measures the number of times profit will increase or decrease in
7. Operating Leverage = Contribution Margin / EBIT
relation to change in net sales.
Measures the adequacy of current earnings to meet preference
8. Times Preference Dividend Earned = Net Profit / Preference Dividend
dividend payments.
= (Profit – Preference Dividend) / Average Measures the rate of earnings per share of ordinary share; perhaps
9. Earnings Per Share
Ordinary Shares Outstanding the most frequently quoted ratio of earnings and growth performance.
= Adjusted Profit / Adjusted Average Ordinary Shows the potential effect on earnings per share by
10. Diluted Earnings Per Share
Shares Outstanding including potentially dilutive ordinary share equivalents.

2|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
The profitability ratios maybe determined and managed using the Du Point Model, as follows:
▪ ROS = Profit / Net Sales
▪ ROA = Profit / Total Assets

B. LIQUIDITY RATIOS
Type of Ratios Formula Definition

Indicates the amount invested by the business to operate its normal

1. Net Working Capital = Current Assets – Current Liabilities
business activities.

Measures a rough estimate on the ability of the business to meet its

2. Current Ratio = Current Assets / Current Liabilities currently maturing obligations and a measure of adequacy of working
capital. This ratio varies in great disparity from one industry to another.

A more severe test of immediate liquidity to meet its currently maturing

3. Acid Test Ratio or Quick Ratio = Quick Assets / Current Liabilities obligations.
NOTE: Quick Assets = Cash + Marketable Securities + Receivables

Measures the speed of the business cycle; the number of days from
4. Operating Cycle = Days Accounts Receivables + Days Inventory when cash was invested in the normal business operations until its
recovery.
Also called Days in the Cash Flow Cycle. This is the difference
5. Net Cash Cycle = Operating Cycle – Days Accounts Payable
between operating cycle days and payable payment days.

C. ACTIVITY RATIOS

Type of Ratios Formula Definition

1. Accounts Receivable Turnover = Net Credit Sales / Ave. Accounts Receivable Indicates the efficiency in credit and collection policies.

Indicates the number of times inventories were acquired and sold

2. Inventory Turnover = Cost of Goods Sold / Ave. Inventory
during the period.

3|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
 Indicates the number of times materials were used in on the average
3. Materials Turnover = Materials Used / Ave. Materials Inventory
during the period.

= Cost of Goods Manufactured / Ave. WIP Indicates the number of times average work in process inventories is
4. Work In Process Turnover
Inventory converted to finished goods.

= Cost of Goods Sold / Ave. Finished Goods Indicates the number of times average finished goods is sold during
5. Finished Goods Turnover
Inventory the period.
= Net Credit Purchases / Ave. Accounts
6. Accounts Payable Turnover Measures effectiveness in using trade credit facility from suppliers.
Payable
7. Fixed Assets Turnover = Net Sales / Average Fixed Assets Measures effectiveness of asset utilization in terms of fixed assets.

8. Total Assets Turnover = Net Sales / Average Total Assets Measures effectiveness of asset utilization.

Measures the ability of the business to meet operating expenses

9. Cash Turnover = Cash Operating Expenses / Average Cash
payments given a particular balance.

Measures the adequacy and effectiveness in using working capital

10. Working Capital Turnover = Net Sales / Average Working Capital and indicates the reasonableness of the amount of the net working
capital.

11. Current Assets Turnover = Net Sales / Average Current Assets Indicates the reasonableness of the amount of current assets.

Also called Day Sales Outstanding and Average Collection Period.

12. Days Accounts Receivable = 360 / Accounts Receivable Turnover
This Measures quickness in collecting trade receivables.

Also called Average Conversion Period, Average Sale Period or

13. Days Inventory = 360 / Inventory Turnover
Number of Days to sell inventory.

Also called Average Payment Period. This indicates the length of time
14. Days Accounts Payable = 360 / Accounts Payable Turnover
spent before the average inventory is sold to customers.

Also called Days to pay operating expenses. This indicates the

15. Days Cash = 360 / Cash Turnover
number of days spent before meeting operating expense payments.

4|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
IMPORTANT NOTE:
▪ If no Net Credit Sales given, use the following order of priority: Net Sales and Gross Sales.
▪ If no Net Credit Purchases given, use the following order of priority: Net Purchases and Gross Purchases.
▪ If no Cost of Goods Sold given, use Net Sales.
▪ Default number of days is 360 days, otherwise stated in the problem.

D. SOLVENCY AND LEVERAGE RATIOS

Type of Ratios Formula Definition

1. Debt Ratio or Debt-to-Assets Ratio = Total Debt / Total Assets Measures the share of creditors over the total resources of the firm.

2. Equity Ratio or Equity-to-Assets Ratio = Total Equity / Total Assets Measures the amount of resources provided by the owners in the firm.

Measures the use of debt to finance operations and provides a

3. Debt-Equity Ratio = Total Debt / Total Equity measure of the relative amount of resources contributed by the
creditors and owners.
= Total Assets / Total Equity
4. Equity Multiplier or Leverage Ratio Indicates the number of times owner’s equity is multiplied.
= 1 / Equity Ratio
Measures the long-term debt paying ability of the firm. A high number
5. Times Interest Earned Ratio = EBIT / Interest Expense ratio indicates that the business is under-leveraged and its return on
ordinary equity could still be improved.
= EBIT / (EBIT – Interest Expense – Preferred
6. Financial Leverage Measures the risk associated in using debt to finance investments.
Dividends)
A rough estimate of the firm’s ability to meet interest payment to
7. Assets to Debt Ratio = Total Assets / Total Debt
creditors.

8. Noncurrent Assets to Long Term Shows the capability of the firm to meet non-current liabilities using
= Noncurrent Assets / Long Term Liabilities
Liabilities Ratio non-current resources.

5|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
E. GROWTH OR MARKET TEST RATIOS
Type of Ratios Formula Definition

Measures the number of years investment in the equity share will be

1. Price Earnings Ratio = Market Price Per Share / Earnings Per Share recovered and measures the profitability of the firm in relation to the
market value of the share.

2. Dividend Yield Ratio = Dividend Per Share / Market Price Per Share Measures the rate of cash return to investment in equity share.

= Dividend Per Share / Earnings Per Share Represents the percentage of profit distributed as dividends; low
3. Dividend Payout Ratio = Dividend / Net Income payout ratio may indicate a high investment of profits by a growth-
= 100% - Retention Ratio oriented firm.

Calculates the proportion of the current price per share to the earnings
4. Earnings Yield Ratio = Earnings Per Share / Market Price Per Share
per share.

Indicates the value of the share on cost perspective; the relevance of

this ratio diminishes when the statement of financial position valuation
5. Book Value Per Share = Total Equity / Total Outstanding Shares
does not approach the fair market values; may be computed for both
ordinary and preference shares.

Computation of Preference Shareholders’ Equity:

= Total Preferred Equity / Total Outstanding Liquidation (Callable or Redemption) Value xx
6. Book Value Per Preference Share
Preferred Shares + Applicable Preference Dividends xx
Preference Shareholders’ Equity xx

Computation of Ordinary Shareholders’ Equity:

= Total Ordinary Equity / Total Outstanding Total Shareholders’ Equity xx
7. Book Value Per Ordinary Share
Ordinary Shares – Preference Shareholders’ Equity xx
Ordinary Shareholders’ Equity xx

Establish a relationship between the book values and the actual

= Market Price Per Share / Book Value Per
8. Market to Book Value Per Share market price of the stock; suggests how much investors are paying
Share
against each dollar of book value of the balance sheet.

6|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
NOTE:
▪ The ordinary shareholders’ equity is also referred to as “residual equity”.
▪ The applicable preference dividends (those dividends not yet paid) for book value per share computation depend on the type of preference share as either cumulative
or non-cumulative preference share.

Dividends Cumulative Preference Share Non-Cumulative Preference Share

Dividends in Arrears Included Excluded
Current Dividends Included Included only when declared

7|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
 ILLUSTRATIVE PROBLEM:

The financial statements of ESCAPE COMPANY are provided as follows:

ESCAPE COMPANY
Income Statement
For the year ended December 31, 2018

Gross Sales 5,500,000

Less: Sales Returns & Allowances 500,000

Net Sales 5,000,000

Cost of Goods Sold 3,000,000
Gross Profit 2,000,000
Operating Expenses:
Doubtful Accounts Expense 50,000
Depreciation Expense 450,000
Rent Expense 100,000
Advertising Expense 75,000
Taxes & Licenses 50,000
Salaries Expense 150,000 875,000
Operating Income / EBIT / PBIT 1,125,000
I nterest Expense 125,000
Income Before Tax / EBT / PBT 1,000,000
I ncome Tax Expense (30%) 300,000
Income After Tax / Net Income / Profit 700,000

Net Income / Profit 700,000

Preference Dividends 200,000
Profit Available to Ordinary Shareholders (PAOS) 500,000

ESCAPE COMPANY
Statement of Changes in Shareholders Equity
For the year ended December 31, 2018

Common Preferred Share Retained TOTAL

Stock Stock Premium Earnings

Beginning, Balances, Jan 1, 2018 3,000,000 2,000,000 1,000,000 500,000 6,500,000

Issuance of Common St ock 400,000 225,000 625,000
Net Income (Profit) 700,000 700,000
Preference Dividends - 200,000 - 200,000
Dividends to Common Stock - 125,000 - 125,000
Ending Balances, Dec. 31, 2018 3,400,000 2,000,000 1,225,000 875,000 7,500,000

8|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA
 ESCAPE COMPANY
Comparative Statement of Financial Position
As of the years ended December 31, 2017 and 2018

2017 2018

Cash 250,000 625,000

Marketable Securities 500,000 375,000
Accounts Receivable 750,000 1,250,000
Allowance for Doubtful Accounts - 75,000 - 125,000
I nv entories 625,000 500,000
Prepaid Expenses 375,000 500,000
Total Current Assets 2,425,000 3,125,000

Long-term I nv estments 3,750,000 4,375,000

Property, Plant and Equipment 7,500,000 7,500,000
Accumulated Depreciation - 1,675,000 - 2,125,000
Other Assets 500,000 375,000
Total Noncurrent Assets 10,075,000 10,125,000

TOTAL ASSETS 12,500,000 13,250,000

Accounts Payable 500,000 375,000

Accrued Expenses 250,000 375,000
Short-term Bank Notes Payable 750,000 500,000
Total Current Liabilities 1,500,000 1,250,000

Bonds Payable 2,000,000 1,000,000

Long-term Notes Payable 2,500,000 3,500,000
Total Noncurrent Liabilities 4,500,000 4,500,000

Ordinary Share Capital, P100 par value 3,000,000 3,400,000

10% Preference Shares, P160 par value 2,000,000 2,000,000
Share Premium 1,000,000 1,225,000
Retained Earnings 500,000 875,000
Total Shareholders’ Equity 6,500,000 7,500,000

TOTAL LIABILITIES & EQUITY 12,500,000 13,250,000

Additional Information:
1. The Liquidation Value of Preference Shares is P200/share.
2. The dividends on both preference and ordinary shares had been declared and paid.
3. Let us assume the cost of goods sold is purely variable cost while the operating expenses
(except Doubtful Account Expense) are fixed costs.
4. 90% of sales to customers are made on credit while the remaining 10% represents cash sales.
5. All purchases are made on credit.
6. The ordinary shares are now currently selling at a quoted price of P150.

Requirement: Compute all the financial ratios provided by this handout.

9|P age
FINANCIAL MANAGEMENT HANDOUT 2304
MYLENE P. ALFANTA, CPA