FUNDAMENTALS OF ACCOUNTANCY,

BUSINESS, AND MANAGEMENT 2 MODULE

Module No. 7: Week 7: First Quarter

ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS 2

LEARNING COMPETENCIES
1. Define the measurement levels, namely, liquidity, solvency, stability,
and profitability.
2. Compute and interpret financial ratios such as current ratio, working
capital, gross profit ratio, net profit ratio, receivable turnover, inventory
turnover, debt-to-equity ratio, and the like.

CODES: ABM_FABM12Ig-h-12 & ABM_FABM12-Ig-h-14

OBJECTIVES

1. Know the definition of different financial ratios, liquidity,

solvency/stability and profitability.
2. Answers the activities about the measurement levels, liquidity,
solvency/stability and profitability.
3. Know the formula in computing financial ratios such as current ratio,
working capital, gross profit ratio, net profit ratio, receivable turnover,
inventory turnover, debt-to-equity ratio.
4. Solve for financial ratios such as current ratio, working capital, gross
profit ratio, net profit ratio, receivable turnover, inventory turnover,
debt-to-equity ratio.

LET’S RECALL
Excellent! Another accomplished module and another to accomplish. In
this module, it will challenge your mathematical skills. Before we proceed with the discussion,
let us first recall the concepts from your previous modules by answering the following
exercises.

A. Identify the following accounts as what financial statement they can be reflected. Write
SFP for Statement of Financial Position, SCI for Statement of Comprehensive Income,
SCE for Statement of Change in Equity.

1. Gross profit 2. Cash

3. Cost of Goods Sold 4. Net Sales

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 5. Total Current Asset 6. Accounts Receivable

7. Net Income 8. Total Current Liabilities

9. Total Owner’s Equity 10. Operating Expenses

LET’S UNDERSTAND
The last and vital phase of the accounting process is the analysis and
interpretation of all the contents in the financial statements. This
interpretation will be beneficial in making economic decisions that will
lead to business’ success.

As explained in your previous module, Financial Statement (FS) Analysis is the

process of evaluating risks, performance, financial health, and future prospects of a business
by subjecting financial statement data to computational and analytical techniques with the
objective of making economic decisions(White et.al 1998). There are three kinds of FS
analysis techniques – Horizontal, Vertical, and Financial Ratios. We are than with the first two
analysis, therefore, in this module we will be focused on the ratio analysis.

Ratio analysis expresses the relationship among selected items of financial statement
data. The relationship is expressed in terms of a percentage, a rate, or a simple proportion.
A financial ratio is composed of a numerator and a denominator. For example, a ratio that
divides sales by assets will find the peso amount of sales generated by every peso of asset
invested. This is an important ratio because it tells us the efficiency of invested asset to create
revenue. This ratio is called asset turnover. There are many ratios used in business.

These ratios are generally grouped into three categories: (a) profitability, (b) efficiency,
and (c) financial health.

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. The following are the
commonly used profitability ratios: -

A. Gross profit ratio reports the peso value of the gross profit earned for every peso
of sales. We can infer the average pricing policy from the gross profit margin.

B. Operating income ratio expresses operating income as a percentage of sales. It

measures the percentage of profit earned from each peso of sales in the company’s
core business operations (Horngren et.al. 2013). 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 et.al. 2013).

C. Net profit ratio 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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 D. Return on Asset (ROA) 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. 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 are
computed as beginning balance + ending balance divided by 2.

E. Return on Equity (ROE) measures the return (net income) generated by the
owner’s capital invested in the business. Similar to ROA, the denominator of ROE
may also be total equity or average equity.

Here are the sample financial statements to be used for the computations:

Operational efficiency ratio measures the ability of the company to utilize its assets.
Operational efficiency is measured based on the company’s ability to generate sales from the
utilization of its assets, as a whole or individually. The turnover ratios are primarily used to
measure operational efficiency.

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 A. Asset turnover measures the peso value of sales generated for every peso of the
company’s assets. The higher the turnover rate, the more efficient the company is
in using its assets.

B. Fixed asset turnover is indicator of the efficiency of fixed assets in generating sales.

C. Inventory turnover is 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. An alternative to inventory
turnover is “days in inventory”. This measures the number of days from acquisition
to sale.

D. Accounts receivables turnover the measures the number of times the company
was able to collect on its average accounts receivable during the year. An
alternative to accounts receivable turnover is “days in accounts receivable”. This
measures the company’s collection period which is the number of days from sale
to collection.

Financial Health Ratios look into the company’s solvency and liquidity ratios.
Solvency refers to the company’s capacity to pay their long-term liabilities. On the other
hand, liquidity ratio intends to measure the company’s ability to pay debts that are coming
due (short term debt).
A. Debt ratio indicates the percentage of the company’s assets that are financed by
debt. A high debt to asset ratio implies a high level of debt.

B. Equity ratio indicates the percentage of the company’s assets that are financed
by capital. A high equity to asset ratio implies a high level of capital.

C. Debt to equity ratio indicates the company’s reliance to debt or liability as a

source of financing relative to equity. A high ratio suggests a high level of debt
that may result in high interest expense.

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D. Interest coverage ratio measures the company’s ability to cover the interest
expense on its liability with its operating income. Creditors prefer a high
coverage ratio to give them protection that interest due to them can be paid.

E. Current ratio is used to evaluate the company’s liquidity. It seeks to measure

whether there are sufficient current assets to pay for current liabilities. Creditors
normally prefer a current ratio of 2.

F. Quick ratio is a stricter measure of liquidity. 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.

LET’S APPLY

Let us test your understanding in this module. Solve for the

Profitability ratio, Operating Efficiency, and Financial Health of the given
SFP and SCI below.

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 LET’S ANALYZE
Using the balances from Iyahmra Company’s statement, solve
the financial ratios below.

Find the following ratios:

1. Current Ratio = _______________

2. Quick Ratio = __________________
3. Account Receivable Turnover Ratio = _____________
4. Inventory Turnover Ratio = ________________
5. Gross Profit Ratio = ______________
6. Net Profit Ratio = __________________
7. Debt to Equity Ratio = _______________

LET’S TRY
Great! You are now on the part of the module where we will
assess your mastery of the concept. Answer the following exercises
below and write your answer on the space provided.

Part I. Multiple Choice Problems: For items 1 to 5, based your

answers on the attached statement of Yasha Trading Ltd. below.

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 1. Yasha Trading Ltd.’s inventory turnover during 2014 was (amounts rounded)
A. 6 times.
B. 7 times
C. 8 times.
D. Not determinable from the data given.
2. Which statement best describes Yasha Trading Ltd.’s acid-test ratio?
A. Greater than 1
B. Equal to 1
C. Less than 1
D. None of the above
3. Which measure expresses Yasha Trading Ltd.’s times-interest-earned ratio? (amounts
rounded)
A. 54.7%
B. 20 times
C. 34 times
D. 32 times
4. Yasha Trading Ltd.’s rate of return on equity can be described as
A. 33.55%
B. 16.72%
C. 35.29%
D. None of the above
5. During 2014, Yasha Trading Ltd.’s days’ sales in receivables ratio was (amounts rounded)
A. 34 days
B. 30 days
C. 32 days
D. 28 days
6. Yasha Trading Ltd.’s gross profit rate can be described as
A. 34%
B. 19%
C. 20%
D. 66%
7. Yasha Trading Ltd.’s rate of return on asset can be described as
A. 33.55%
B. 16.72%
C. 35.29%
D. None of the above

Part II. Problem 1. Using the statements below, compute for the company’s profitability and
operating efficiency ratios for 2014 and financial health ratio in 2014 and 2013

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Problem 2. Fill in the missing data in Alice’s Cupcake’s Statement of Comprehensive
Income using the following ratios:

A. Inventory turnover is 3.50. Beginning inventory was P4,250 and ending inventory
was P4,050.
B. Net profit margin is 11%.

Problem 3. Fill in the missing data by using the following ratio to complete Grandma’s
Cooking Company’s balance sheet:
A. Current ratio is 0.80.
B. Acid-test ratio is 0.40.

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Signature of Parent over printed name