Analysis and Interpretation of Financial Statements 2

Financial Mix Ratio Analysis

❖ Is an analytical tool employing the ratio or proportion of certain item in the financial
statement vis-ā-vis other related items in the same financial statements or other
statements to determine comparative performance.
❖ Is performed by comparing two items in the financial statements. The resulting ratio can
be interpreted in a way that is not possible when interpreting the items separately.
❖ In financial ratio analysis, the item in the statement of financial position or SCI being
evaluated or compared is assumed to have direct relationship with other items in the
statements.

Classification of Financial Ratios

There are four basic classifications of financial ratios:

1. Liquidity Ratios
2. Solvency or Stability Ratios
3. Profitability Ratios
4. Growth Ratios

The focus of the evaluation is to determine the tendencies of the company`s liquidity, solvency,
profitability, and efficiency of management performance. The result of the studies assists the
management in identifying deficiencies and appropriate actions to improve the operating
performance.

Liquidity Analysis
❖ This analysis is focused primarily on the ability of a business to settle its currently maturing
obligation; hence, the analysis evaluates the changes on current assets, current liabilities,
and related items affecting them.

Liquidity Ratios

❖ Are a group ratio that measure the ability of the business firm to pay off short-term
obligations as they mature.
❖ These ratios show the relationship of the firm`s current assets to current liabilities.
❖ These ratios basically answer the question, “Will the business firm be able to pay it`s
currently maturing obligations when they fall due?”
The ratios commonly used to evaluate the liquidity status of the business firm are:
1. Current Ratio
2. Quick or Acid Test Ratio
3. Receivable Turnover
4. Average Collection Period
5. Inventory Turnover
6. Average Sales Period

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Current Ratio

❖ Used to evaluate the company’s liquidity. It

seeks to measure whether there are sufficient
current assets to pay for current liabilities.
❖ Indicates the extent to which the current
liabilities are covered by the current assets
❖ Most commonly used measure of short-term
solvency because it serves as a single indicator
of the extent to which the claims of short-term
creditors are covered by the current assets.
❖ Creditors normally prefer a current ratio of 2.

Example:

The current ratios for years ended 2018 and 2017 appear as follows:

2018: (433,000/168,500) = 2.57:1.00

2017: (393,500/147,000) = 2.68 :1.00

The current ratio of 2.68:1 in year 2017 indicates that for every 1 current liability, the company
has an available amount of 2.68 current assets.

Interpretation:
1. The current ratio of 2.57:1 in 2018 indicates that the business appears to be liquid since it
has more current assets to settle its current liabilities.
2. The decrease of current ratio from 2.68 to 2.57 may appear to be unfavorable trend since
the increase in current liabilities is faster than the current assets.

In evaluating whether the current ratio is favorable or unfavorable, the analyst shall consider the
industry average and the individual items comprising the current assets and current liabilities. A
ratio standing alone is meaningless, and it will never provide valuable information to the interested
users.

Note:
▪ Usually the Current Ratio is known as IDEAL RATIO
▪ If the Current Ratio is lower than 1, it is a warning sign for company.
▪ If the Current Ratio is higher than 1, it is beneficial for company.

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Quick or Acid Test Ratio

❖ is a stricter measure of
liquidity because it does not
consider all the current assets,
only those that are easier to
liquidate such as cash and
accounts receivable that are
referred to as quick assets.
❖ Is a more stringent measure
of the liquidity status of a
business firm since some current
assets are not included in the
computation.
❖ By reducing the amount of current assets, the quick asset test ratio, in all instances, will
be lower than the current ratio.
❖ Refers to Assets owned by a company with a commercial or exchange value that can
easily be converted into cash or that is already in a cash form.
❖ Highly liquid assets held by a company including short-term investments and accounts
receivables.

Example:

2018: 121,000⁄168,500=0.72:1
2017: 148,000⁄147,000 =1.00:1

Interpretation:
The exclusion of inventories and prepaid expenses from the current assets resulted in a
significant drop of the ratios between the current asset ratio and quick acid test. This result clearly
indicates that the business has a significant amount of resources in the inventory.

Receivable Turnover

❖ Also referred to as Accounts

Receivable Turnover, a liquidity ratio that
focuses on the relationship between
sales and accounts receivable.
❖ Measures the number of times the
company was able to collect on its
average accounts receivable during the
year.
❖ Measures the velocity of conversion
of trade receivables into cash during the
year.
❖ It answers the question: How many
times during the year has a receivable
been converted into cash?

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❖ Considered an asset management ratio since it measures the effectiveness of the

management in handling its resources.
❖ It also measures the efficiency of the collection effort and credit policy of the business.

Example:
3,270,000
2018: = 13 times
(227,000 +276,000)/2

2,915,000
2017: = 10.56 times
276,000
*Since no data is available on the beginning balance of 2017 accounts receivable, the ending
balance serves as the denominator.

Interpretation:
The company converted its receivable into cash 13 times during the year against 10.56 times in
2017.

This may indicate two tendencies:

1. The quality of receivable may improve which means that good credit policy may have been
adopted.
2. The company may have instituted a better collection strategy, or has selected a good
collection agent.

Average Collection Period

❖ Alternative names are “days in

accounts receivable” and “daily sales
outstanding”.
❖ This measures the company’s
collection period which is the number of
days from sale to collection.
❖ Measures the speed of collecting
trade receivables.
❖ It represents the average length of
time that the business must wait to
receive cash after making sales.

The average daily sales is computed by dividing the annual sales by 360 days. Conventionally,
the computation of collection period is based on a 360-day year. However, if the company is using
a 365-day year then such should be followed.

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Example:

2018: 360 𝑑𝑎𝑦𝑠⁄13 = 27.69 days or 28 days

2017: 360 𝑑𝑎𝑦𝑠⁄10,56 = 34.09 days or 34 days

Using the second formula:

2018: [(227,000 + 276,000)⁄2]/ (3,270,000⁄360)= 27.69 days

2017: 276,000⁄(2,915,000/360) = 34.09 days
Interpretation:
1. The ratio reveals that on average the accounts receivable is being collected every 28 days
in 2018. Comparing the current average collection period from last year, it appears that
there is improvement on the trend.
2. The collection period is usually evaluated by comparison with the terms of sale. In 2018,
it can be viewed as good since average collection period is within the 30-day term;
however, in 2017 the collection period may be viewed as unfavorable and may indicate
that customers are noy paying their accounts on time.

Inventory Turnover
❖ Measures the number of times
inventories are acquired and sold during
the year.
❖ Measured based on cost of goods
sold and not sales. As such both the
numerator and denominator of this ratio are
measured at cost.
❖ It is an indicator of how fast the
company can sell inventory.
❖ This indicates that a high inventory
turnover is favorable to the business.
❖ The inventory turnover varies from
one industry to another. The nature of the
business and the type of goods (Ex.
Consumer or industrial) are factors that
must be considered in evaluating the
inventory turnover.

Example:

2,100,000
2018 = = 13 times
(604,000+476,000)/ 2

1,900,000
2017 = = 10.56 times
476,000
Interpretation:
The inventory turnover improves in 2018 compared to 2017 performance. Generally, a higher
inventory turnover is favorable and preferable over low inventory turnover since it indicates
management efficiency in handling its inventory.

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Average Sales Period

❖ Also called “days in inventory” and
“conversion period”.
❖ This measures the number of days
from acquisition to sale.
❖ Measures the length of time to sell
the inventory to customers.
❖ Generally, low sales period is
favorable to the company since it
indicates that only few days needed to
sell the inventory.

Example:

2018: 360 𝑑𝑎𝑦𝑠⁄3.89 = 93 days

2017: 360 𝑑𝑎𝑦𝑠⁄4.0 = 90 days
Interpretation:
In 2018, the average sales period increases from 90 to 93 days which may indicate that the
company either has been carrying slow moving items or the management has been inefficient in
convincing customers to buy its products.

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Solvency Ratios
❖ Known as stability ratios, are a group of financial ratios that measure the ability of a
business to settle its financial obligation when they mature and to remain still financially
stable.
❖ It is defined as the firm`s potential to carry on business activities in the foreseeable future,
so as to expand and grow.
❖ It is the measure of the company`s capability to fulfill its long-term financial obligations
when they fall due for payment.
❖ A business with favorable solvency ratios appears to have most of the funds provided by
the owner or owners instead of the creditors.
❖ The different ratios under this category also reflect the extent to which a firm utilizes debt
financing, they are also called financial leverage ratios.

Financial Leverage Ratios

Leverage is the act of increasing from the current status. It is divided into two:
1. Operating Leverage – affects the short-term investment and non-current assets of an
entity of the left-hand side of the Statement of Financial Position. It also concerned with
how fixed cost influences the operations of the company.
2. Financial Leverage- affects the right-hand side of the Statement of Financial Position or
the short-term debt, long-term debt, and shareholders’ equity. It reflects the amount of
debts utilized in the capital structure of the business firm.

The commonly used financial leverage ratios are:

1. Debt Ratio
2. Equity Ratio
3. Debt to Equity Ratio
4. Times Interest Earned

Debt Ratio

❖ Measures the proportion of funds provided

by creditors on the total resources of the business.
❖ Indicates the percentage of the company’s
assets that are financed by debt.
❖ This ratio reflects the percentage of total
assets that are financed with debts or by the
creditors
❖ Debt ratio answers the question, “Of the total
resources, how much is provided by the creditors?”
❖ A high debt to asset ratio implies a high level
of debt.

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Creditors prefer low debt ratio because their investments are generally protected by a higher
proportion of shareholders’ funds in the event of liquidation. On the other hand, shareholders
prefer to have high leverage because it will improve the expected return of their investments.
Generally, a debt ratio of 50% debt and 50% equity is considered the fair minimum level for both
creditors and shareholders.

Example:

2018: 1,337,000⁄4,866,000 = 27.48% or 0.2748:1.00

2017: 1,294,000⁄4,012,000 = 32.25% or 0.3225:1.00

Interpretation:
1. Of the total resources of the business in 2017, 32.25 % has been provided by the creditors.
2. The debt ratio in 2018 has improved to 27.48%. This information may indicate that the
business does not rely heavily on funds provided by the creditors.
3. In general, the debt ratio for the two years is considered highly favorable from the
perspective of creditors because it does not reach the generally considered maximum
level.

Equity Ratio

❖ Determines the proportion of resources provided by

the owner or owners of the business.
❖ Indicates the percentage of the company’s assets
that are financed by capital.
❖ It presents the financial strengths of the business as
it provides the margin of safety that the company affords
to creditors.
❖ A high equity to asset ratio implies a high level of
capital.

Example:

2018: 3,529,000⁄4,866,000 = 72.52% or 0.7252:1.00

2017: 2,718,000⁄4,012,000 = 67.75% or 0.6775:1.00

Interpretation:
1. It may appear in 2017 that the owner of the business provided 67.75% of the total
resources used in the operation.
2. The trend of the equity ratio improved in 2018 to 72.52%. It is a clear indication that the
business is not highly dependent on creditors fund in financing its operation.

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3. The equity ratio appears to be attractive to the eyes of the prospective creditors since
more than 50% of the total resources have been provided by the owners.

Debt to Equity Ratio

❖ Measures the proportion of debt and equity

in the capital structure of the business.
❖ Indicates the company’s reliance to debt or
liability as a source of financing relative to equity.
❖ Also indicates whether the company favor
risk in its capital structure or not.
❖ When a debt-to-equity ratio is more than 1 or
more than 100% the company has a riskier capital
structure since debts imply payments of interests.
❖ A high ratio suggests a high level of debt that
may result in high interest expense.

Example

2018: 1,337,000⁄3,529,000 = 37.89% or 0.3789:1.00

2017: 1,294,000⁄2,718,000 = 47.61% or 0.4761:1.00

Interpretation:
1. The debt-to- equity ratio of 47.61% in 2017, in its simplest term, may suggest that the
creditors have provided 0.47 centavos for every P1.00 supplied in by the owner of the
business.
2. The debt –to-equity ratio of the business improved in 2018 to 37.89%. It may suggest that
the owner has provided more funds to the business than what is provided by the creditors.

Times Interest Earned (TIE)

❖ Also known as “Interest coverage ratio”

❖ Is a tool that measures the debt paying ability
of the business.
❖ Measures the company’s ability to cover the
interest expense on its liability with its operating
income.
❖ It reflects the degree of protection provided
by an entity to its long-term creditors.
❖ It is favorable to investors if the business firm
has higher ratio of times interest earned.
❖ Creditors prefer a high coverage ratio to give
them protection that interest due to them can be
paid.

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❖ This measure will test the ability of the operating activities of the business to cover the
amount of interest expense.

Example

2018: 600,000⁄100,000 = 6.0 times

2017: 460,000⁄100,000 = 4.6 times

Interpretation:
1. The time interest earned in 2017 indicates that the operating income of the business
before payment of interest can cover the interest expense for 4.6 times.
2. The time interest earned ratio has improved in 2018 to 6 times. The income from operation
is sufficient enough to shoulder the cost of borrowing.
3. A higher times interest earned ratio of the business appears to be favorable from the
perspective of the creditors.

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Profitability Ratios

❖ Measure the ability of the company to generate income from the use of its assets and
invested capital as well as control its cost.
❖ Reflect the combined effects of liquidity and management efficiency in handling the assets
and liabilities relative to the operations of the business.
❖ Show the effectiveness of business operations

The common measures of profitability are:

1. Gross Profit Rate
2. Operating Profit Margin
3. Net Profit Margin
4. Return on Investments
5. Return on Equity

Gross Profit Rate

❖ Also known as “gross profit ratio” and “gross profit margin”.

❖ Measures the percentage of gross profit to sales.
❖ Reports the peso value of the gross profit earned for
every peso of sales.
❖ Measures the percentage of gross profit margin
available to cover the operating expenses for the
period.
❖ Use to infer the average pricing policy from the gross
profit margin.
❖ Reveals the percentage of cost of sales to sales.

Example:

2018: 1,170,000⁄3,270,000 = 35.78%

2017: 1,015,000⁄2,915,000 = 34.82%
Interpretation:
1. The gross profit rate in 2018 slightly improved against the 2017 operations. The rate may
indicate that in 2018 the business has 35.78% margin available to cover the operating
expenses.
2. It is favorable for the business to have a higher gross profit rate.

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Operating Profit Margin

❖ Also known as “operating income ratio” or,

simply, “operating margin”.
❖ Expresses operating income as a
percentage of sales.
❖ Measures the percentage of profit available
after deducting the cost of Sales and operating
expenses from the sales.
❖ It measures the percentage of profit earned
from each peso of sales in the company’s core
business operations (Horngren [Link]. 2013).
❖ Difference between the gross profit and
operating expenses.
❖ Reflect the overall efficiency of the management in handling the production, selling and
administrative costs of the business.
❖ A company with a high operating income ratio may imply a lean operation and have low
operating expenses. Maximizing operating income depends on keeping operating costs
as low as possible (Horngren [Link]. 2013).

Example:

2018: 600,000⁄3,270,000 = 18.35%

2017: 460,000⁄2,915,000 = 15.78%
Interpretation:
1. The operating profit improved in 2018 from 15.78% to 18.35%
2. The increase in operating margin may indicate that the business has instituted some
controls to effectively manage the incurrence of cost and expenses.

Net Profit Margin

❖ It is also called “return of sales” or,

simply, “profit margin”
❖ Measures the overall operating
results of an entity.
❖ The measure considers all income
recognized and all expenses incurred
during the period.
❖ Relates the peso value of the net
income earned to every peso of sales.
This shows how much profit will go to the
owner for every peso of sales made

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Example:

2018: 350,000⁄3,270,000 = 10.70%

2017: 252,000⁄2,915,000 = 8.64%
Interpretation:
1. The net profit margin of the business has provided positive contributions to the equity of
the owner after the provisions for interest and taxes.
2. The contribution of the business operating performance to the owner`s equity has
improved in 2018 compared to 2017.

Return on Investments (ROI)

❖ Also called “return on assets” (ROE)

❖ Measures the peso value of income generated by employing the company’s assets. It is
viewed as an interest rate or a form of yield on asset investment.
❖ Measures the amount of net income per peso of investment in a business. The ratio
reflects the profitability of every peso invested by the owner.
❖ Higher ROI is generally favorable to the business
❖ The numerator of ROA is net income. However, net income is profit for the shareholders.
On the other hand, asset is allocated to both creditors and shareholders.
❖ Some analyst prefers to use earnings before interest and taxes instead of net income.
There are also two acceptable denominators for ROA – ending balance of total assets or
average of total assets. Average assets is computed as beginning balance + ending
balance divided by 2.

Generally, the formula to compute ROI is:

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However, if the business has interest-bearing liabilities, ROI is computed as:

Example:

350,000+[100,000 (1−0.30)]
2018: = 9.46%
(4,866,000+4,012,000)/2

252,000+[100,000 (1−0.30)]
2017: = 8.03%
4,012,000

Interpretation:
1. The ROI slightly increased from 8.03% in 2017 to 9.46% in 2018.
2. This trend may indicate favorable movement in return to investment.
3. The ROI can be read as: there are 0.0946 centavos return for every P1.00 invested on
the assets.
4. However, in 2017, the return was only 0.0803 centavos for every P1.00 investments on
assets.

Return on Equity (ROE)

❖ Measures the rate of return on the investment of the owner.

❖ Measures the return (net income) generated by the owner’s capital invested in the
business.
❖ In corporations, this measure applies only to ordinary shares since preference shares
normally have fixed rate of return.
❖ Similar to ROI, the denominator of ROE may also be total equity or average equity.

For sole proprietorship, ROE is computed as:

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For corporation, the formula for ROE is:

Example:

2018: 350,000⁄(3,529,000 + 2,718,000)/2 = 11.21%

2017: 252,000⁄2,718,000 = 9.27%
Interpretation:
The trend on the ROE may indicate improvement in year 2018 compared to 2017 financial
operation.

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Growth Ratios

❖ Also called “market value ratios”

❖ Reflect the value of the shares to their earnings, book value per share, and cash flow.
❖ These basically are applicable only to corporations.
❖ Generally, if the liquidity, solvency, and profitability ratios are favorable or the trends
indicate improvement, then growth ratios will look good to investors.

The following growth ratios are commonly used:

1. Earnings per Share
2. Price-earnings Ratio
3. Dividend-yield Ratio
4. Dividend-payout Ratio
5. Book Value per Share

Earnings per Share

❖ Measures the value of ordinary shares relative to the earnings of the business.
❖ Only the net income attributable to ordinary shares shall be included in the computation;
hence, dividends applicable to preference shares shall be deducted from net income.
❖ When the preference shares are non-cumulative, only the dividends declared in respect
to the period shall be deducted.
❖ However, if the preference shares are cumulative, all required dividends applicable,
whether declared or not, shall be deducted from the net income.
❖ The two kinds of earnings per share are basic earning and diluted earnings.

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Price-earnings Ratio

❖ Measures price per share in

relation to the earnings of the
company.
❖ This measure also reflects the
amount the investor is willing to pay
for every 1 peso of current earnings

Dividend-yield Ratio

❖ Dividends represent earnings of the

company distributed to the shareholders in
proportion to their investments.
❖ Measures the amount of dividends in relation
to the market.

Dividend-Payout Ratio

❖ It is also known as “payout ratio”

❖ The ratio of the total amount of dividends paid out to shareholders relative to the net
income of the company.
❖ The proportion of earnings paid out as dividends to shareholders, typically expressed as
a percentage.
❖ It is the percentage of earnings paid to shareholders in dividends.
❖ The amount that is not paid to shareholders is retained by the company to pay off debt or
to reinvest in core operations.

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Book Value per Share

❖ Measures the amount payable to each share based on the realizable amount of assets in
the event of liquidation.
❖ The measure applies to both ordinary shares and preference shares.

Reference:
Commission on Higher Education. (2016). Teaching Guide for Senior High School, Fundamentals of Accountancy, Business, and Management 2.
Quezon City, EC-TEC Commercial.
Aduana, N. (2017). Fundamentals of Accountancy, Business, and Management 2. Quezon City, C & E Publishing, Inc.
Hayes, A. (2020, September 16). Dividend Payout Ratio Definition. Retrieved September 30, 2020, from
[Link]

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