Senior High School

Fundamentals of
Accountancy
Business and
Management 2
Quarter 1 –Module 5.2
Tools for Analysis and
Interpretation of
Financial Statements
(Financial Ratios)

Writer:
BETHEL GRACE M. GUIAO
TIII SAN JUAN HIGH SCHOOL

Editors:
JANE P. VALENCIA, ED.D., EPS-Mathematics
NESSA B. DIMALANTA – Teacher II
VIENNAH MARIE M. BUSTOS Teacher II SSA B. DIMALANTA
T-II BACOLOR HIGH SCHOOL

tors: . VALENCIA, ED. D., EPS –

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 What I Need to Know

This module was designed and written with you in mind. It is here to help
you master the subject Fundamentals of Accountancy, Business and Management II – G12
particularly the Analysis and Interpretation of Financial Statements. The scope of this
module permits it to be used in many different learning situations. The language used
recognizes the diverse vocabulary level of students. The lessons are arranged to follow the
standard sequence of the course. But the order in which you read them can be changed to
correspond with the textbook you are now using.

This module will cover financial statement analysis, namely:

Lesson 1 – Tools for Analysis and Interpretation of Financial Statements
(Financial Ratios) namely liquidity, solvency, stability and profitability

After going through this module, you are expected to:

1. Determine the different financial ratios.
2. Calculate and interpret financial ratios including profitability, liquidity, solvency,
efficiency (Turnover Ratios)

What I Know

PRE-ASSESSMENT. Choose the letter of the best answer. Write the chosen letter on a
separate sheet of paper.
1. In which line of business would you expect the Inventory Turnover ratio to be higher?
a. Supermarket c. Appliances
b. Construction supplies d. Clothes and Accessories

2. What consequence will you expect if the inventory days are reduced from 78 to
64?
i. profitability of the business will improve
ii. Liquidity of the business will improve
iii. Operational efficiency of the business will improve
a. i b. i, ii c. i, ii, iii d. no consequence
3. Sales in the year ending 31st March 2012 were P43,200. Identify the gross
profit ratio, as a percentage, if gross profit for the year was P5,400
a. 7% b. 12.5% c. 20% d. 25.7%
4. Which formula is defined by Current assets DIVIDED BY current liabilities?
a. Current Ratio c. Net Worth Ratio
b. Debt Ratio d. Working Capital
5. Which inventory turnover ratio is favorable to a company?
a. 2.4 b. 2.75 c. 3.24 d. 3.79
6. It narrates the connection between the numbers presented in the
financial statement.
a. Financial Ratio Analysis c. Trend Analysis
b. Horizontal analysis d. Vertical Analysis

7. Which is a Profitability Ratio?

a. Inventory Turnover c. Average Sales Period
b. Debt to Equity Ratio d. Return on Assets

8. Which is a Liquidity Ratio?

a. Inventory Turnover c. Profit Margin
b. Debt to Equity Ratio d. Return on Assets

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9. Looking at the items below:

Amount
Cash P410,000
Accounts Receivables 120,000
Merchandise Inventory 235,000
Property, Plant and Equipment 455,000
Accounts Payables 265,000

* Compute the Current Ratio

a. 1.5 b. 2 c. 9.4 d. 2.9

10.Which of the following is unfavorable to the company’s Debt ratio?

a. 64% b. 53% c. 24% d. 15%

Notes to the Teacher

Before starting this module, the teacher should review the learner on the
components of the four major financial statements, as well as his/her Business
Math computation skill in ratios and percentages. Remind the learner that
analysis of a financial statement goes beyond computation, it also involves
interpretation. Be prepared to roll out their analytic minds

In the last module, we looked into the evaluation of the company’s health condition by
putting some numbers and analysis into it, through the horizontal and vertical
analysis. These analyses allowed intra-comparability (compare company’s performance
with itself), inter-comparability (compare company’s performance with a competitor),
and comparison with the industry standard (compare company’s performance with the
industry’s standard average). For this module, we will continue our discussion on
financial statement analysis focusing on financial ratios to dig deeper into the
company’s profitability, liquidity, solvency and efficiency.

What’s New
Let’s look back at the data from Faithful John’s Merchandising from our
previous module:

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While the horizontal analysis was able to make a comparison between the company’s performance
in both years, more essential information can still be drawn on issues like:
1. If a business makes sales, does it mean that it is also making profit?
2. How fast can they sell their inventory?
3. How many days does it take to collect receivables from customers?
4. How much revenue is generated for each peso of asset invested in the business?

Answers to these questions may be taken from financial statements and drawn further through
financial ratios.

What’s In
.

Can you tell which of the two businesses has performed Better?
In the case of Bituin and Tala, both had the same amount of net income of P______________ but
differ in their Net Profit Margin (Bituin: _____%, Tala: ____%). Although Tala showed higher amount
of sales at P_______________, its NPM was _____% lower. This may indicate a weakness of control in
operating costs and expenses.

What is It
Financial ratio analysis compares relationships between financial statement
accounts to identify the strengths and weaknesses of a company.
• They may be interpreted as decimal, percentage or a
proportion.
• They are composed of a numerator and denominator. One number divided by
another number.
•They allow comparison between different companies in the
industry.
•They are used by management and creditors as well.

Let us assume that you are an owner of a business, as an owner, you will surely be interested to
know the performance of your company from different aspects like your company’s ability to pay
debt, how much of asset is utilized to generate income and its operating efficiency. Your business
may make a sale, but it does not guarantee that it is also generating profit for company, this is
where financial ratios can help.
To make you get a clearer picture of your firm’s performance.

Consider the following questions:

How much of my investment is being used to produce income?
How much of my every peso sale goes to net profit?
How fast can my company sell its inventory?
How much time does it take to collect receivables from my customers?

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To have an organized idea, financial ratios are often grouped in categories based on what they measure.
Each of these will be discussed in the following sections.

Remember, in analyzing financial ratios we need to apply the two phases discussed from our
previous module. Do you still remember them?

You have to start with the (computation, interpretation) phase to determine the differences, ratios
and percentages followed by the (computation, interpretation) phase to figure the results and
communicate their meaning to its users.
If you want to check whether a company is effective in making sales while controlling costs and
expenses, you might consider doing profitability ratios.

PROFITABILITY RATIOS- show how well companies use their existing assets to generate profit by
comparing income statement accounts and categories.

To illustrate, using the available data of Milly’s Pet Shop on December 31,2015, Milly’s books
showed an average total asset of P300,000 and a Statement of Comprehensive
Income.

Net Sales P250,000

COGS (120,000)
Gross Profit P130,000
Operating Expenses (60,000)
Operating Income P70,000
Interest Expense (3,000)
Net Income P67,000

PRACTICE ACTIVITY 1. PROFITABILITY. Let’s try to find answers to the following questions below
and look at the appropriate tool used to compute for the ratios under profitability:

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 Note that, the higher the profitability ratios, the more stable a company is considered, as it indicates
that the company is making more from each sale.

The finances of a business must be properly managed to make it successful. As the business grows
bigger, operations become more complex and thus business may enter into debt. A well-managed
business is capable of meeting obligations and reduce the risk for the company.

Although debts may help bring extra cash needed for the growth and expansion of the business, too
much debt can bring the company out of business. Owners must ensure the balance between making
debt and having the ability to pay them back. This is measured by checking the firm’s solvency and
liquidity.
SOLVENCY RATIOS
You will know if the company is solvent if it has greater assets than liabilities. Solvency talks about
the company’s ability to meet its long-term debt while still sustaining itself. Let’s take a look at the
appropriate tools to compute for solvency.

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LIQUIDITY RATIOS
How easy can a company meet its short-term debt? This question can be answered by assessing if the
company is liquid. We say that a liquid company has a lot of cash or cash equivalent on hand. This is
measured by the company’s Current and Quick Ratios.

 In general, a high liquidity ratio shows that a business has cash available
and can safely meet its current liabilities.

Practice Activity 2. SOLVENCY & LIQUIDITY. The following are taken from the
books of Nature’s Merchandise for the year ended December 31, 2016. Write the
formula and compute the following ratios. The first item is done for you.

ACTIVITY 3. INTERPRETING RATIOS. So far, we have already discussed the three

tools. Before moving on to the third, let’s practice interpreting results based on what
has been discussed.
Assume that you are the manager of Pinya Trading. At the end of the year,
financial ratios for your company and your competitor Pilak Trading were presented to
you. Based on how you interpret the data given, tell whether your company is winning,
losing or setting an equal foot with your competitor. Write: WIN, LOSE, or EQUAL
between the ratios. Three items are done to illustrate.

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PINYA WIN/LOSE/EQUAL PILAK

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 Activity 4. Turnover Ratios. Let’s try if you can identify the ratio that can be
computed using the components in the boxes below. Compute and write you answers
on the space provided. The first one is done for you.

What’s More

Answer the following activities on a separate sheet of paper.

INDEPENDENT ACTIVITY 1. Types of Ratios. Identify the type of
ratio listed below based on what it measures. Write the letter of the correct answer on
the blank.
a. Profitability b. Solvency c. Liquidity d. Turnover

_____ 1. Debt- to Equity Ratio _____ 6. Average Sale Period

_____ 2. Times Interest Earned _____ 7. Quick Ratio
_____ 3. Average Collection Period _____ 8. Gross Profit Ratio
_____ 4. Current Ratio _____ 9. Operating Profit Margin
_____ 5. Equity Ratio _____ 10. Return on Assets

INDEPENDENT ASSESSMENT 1. Ratio Formulas. Match the following ratios with

their correct formulas.

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 INDEPENDENT ACTIVITY 2. INTERPRETING RATIOS.
Assume that you are the manager of Dukit Trading. At the end of the year,
financial ratios for your company and your competitor Habi Trading were presented
to you. Based on how you interpret the data given, tell whether your company is
winning, losing or setting an equal foot with your competitor. Write: WIN, LOSE, or
EQUAL between the ratios. Three items are done to illustrate.

DUKIT WIN/LOSE/EQUAL HABI

What I Have Learned

KEYWORDS. Fill in the blanks with the correct answers based on our discussion on
Financial Ratios.
Financial statements can be analyzed in terms of ratios based on what they measure:

I.______________ measures the efficiency of the company in utilizing assets to generate

income.
•It measures the peso sales earned after deducting the cost of goods sold______.
•It measures the rate of income after deducting operating expenses from gross
profit _________.
•It reflects net income as percentage of sales ___________.
•It measures the assets utilized to generate income_________.

II. ___________ measures the company’s ability to pay its creditors as they fall due. •It
tells how much of assets are financed by debts_________.
•It tells how much of assets are financed by equity_________.
•It tells how much of the company depends on debts _________.
•The company’s ability to pay interest from operating income _______.

III. __________ measures company’s performance to pay short term obligations. •The
company’s ability to pay short term debts ________.
•The company’s ability to pay current/immediate debts ________.

IV. _______________ reflects the company’s performance in term of operating efficiency

•It measures how many times a company can sell and replace it inventory____.
•The average time to convert inventory into sales _______.
•The company’s ability to collect from credit customers ______.
•The number of days it takes a business to collect its receivables _______.

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 What I Can Do

APPLICATION I. COMPUTATION. Using the following data available from the

books of Timm’s Fruits Trading. Compute the following ratios for December 31, 2015.

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 APPLICATION 2. INTERPRETATION. From your computed ratios for Timm’s Fruit
Trading. Indicate whether the ratios are FAVORABLE OR NOT FAVORABLE to the
company.

Assessment

Choose the letter of the best answer. Write the chosen letter on a separate sheet of
paper.
1. Which formula is defined by annual sales DIVIDED BY 360 days?
a. Average collection period c. Current Ratio
b. Average sales period d. Average daily sales
2. Which business would possibly have a higher Inventory Turnover ratio?
a. Supermarket c. Appliances
b. Construction supplies d. Clothes and Accessories
3. Which is NOT a Solvency Ratio?
a. Current Ratio c. Gross Profit Ratio
b. Debt Ratio d. Debt to Equity Ratio

4. Sales in the year ending 31st March 2012 were P43,200. Compute for the gross
profit, if the gross profit ratio is 12.5%?
a. P3,200 b. P5,400 c. 7,800 d. P12,300

5. Current Ratio is computed by dividing Current assets by which account?

a. Cost of goods sold c. Current liabilities

b. Quick Assets d. Net income

6. Which inventory turnover ratio is unfavorable to a company?

a. 2.1 b. 2.47 c. 3.24 d. 3.79

7. The debt-to equity ratio of a company is 28% in 2014, and went up to 42% in 2015.
a. This is good for the company c. This has no effect to the company
b. This is bad for the company d. None of the above
8. If the Net Income after tax of a company is P900,000, with a starting asset balance
of P250,000 and ending asset balance of P480,000, what is the return on asset?
a. 2.1 b. 2.47 c. 3.24 d. 3.79

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9. If the company’s Inventory turnover is 4 and uses a 360day/year, what is the
average sales period?
a. 1440 days c. 180 days
b. 960 days d. 90days
10.If total asset is P1,000,000 and the total equity is P350,000, how much is the debt
ratio?
a. .35 b. .65 c. .724 d. .793

Additional Activities

WHICH BUSINESS TO INVEST IN?

You want to invest your savings of P200,000 in a business, which
of the two businesses will you invest in? Calculate the following ratios to
determine the financial health of each business.

I. Compute the following ratios to determine the financial health and condition of each
business

II. Tell which of the two business is your choice and why?

a. By comparing profitability margins, I can tell that ______________________

_____________________________________________________________________________________
______________________________________________________________________________.

b. By comparing solvency ratios, I can tell that ___________________________

_____________________________________________________________________________________
______________________________________________________________________________.

c. By looking into the turnover ratio, I can tell that _______________________

_____________________________________________________________________________________
______________________________________________________________________________.
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Answer Key

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