FUNDAMENTALS OF ACCOUNTANCY, BUSINESS

AND MANAGEMENT 2
Quarter 1 Week 7

Learning Competency:
Compute AND interpret Financial Ratios such as Current Ratio, Working Capital, Gross
Profit Ratio, Net Profit Ratio, Receivable Turnover, Inventory Turnover, Dept-to-Equity
Ratio and the Like

FINANCIAL RATIOS
Financial ratios are tools used for financial analysis. Ratios are the mathematical
relationship between two numbers expressed in percentages, decimals or simple
proportion. A financial ratio is composed of a numerator and a denominator, which is
useful for evaluating a company’s overall ability to generate cash flows from operating
its business. Ratio analysis expresses the relationship among selected items of financial
statement data.
Financial ratios are categorized as follows:

Liquidity Ratios:
1. Current Ratios
 Also known as working capital ratio
 One way to assess the overall liquidity of a company by comparing current
assets to current liabilities
Formula:

Current Ratio = Current Assets

Current Liabilities
2. Quick Ratio
 Also called as acid test ratio

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  Another way to assess the overall liquidity of a firm
 More conservative than current assets, because it does not include all current
ratio in the computation, only those current assets that are quickly convertible
into cash or the quick assets (cash, marketable securities and receivables).
Formula:

Quick Ratio= cash + marketable securities

Current Liabilities

Operational efficiency
1. Asset Turnover ratio
 an indicator of the efficiency with which the company is utilizing all of its assets.
Formula:
Assets Turnover = Net Sales
Average Assets

2. Fixed Asset Turnover

 Measures the efficiency of fixed assets to generate sales.
Formula:
Fixed Assets Turnover = Net Sales
Average Fixed Assets

3. Inventory Turnover
 An indicator of how fast the company can sell its inventory.
Formula:
Inventory Turnover = Cost of Goods Solds
(beginning inventory + ending inventory) / 2

4. Days in Inventory / Age of Inventory

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  Measures the number of days from acquisition to sale.
Formula:
Days of Inventory = 365
Inventory Turnover

5. Accounts Receivable turnover-

 Measures the number of times the company can convert accounts receivable to
cash during the year.
Formula:
Receivables Turnover = Net Sales
(Beginning balance + Ending receivables) / 2

6. Days in Accounts Receivable / Age of Receivables

 computes for the average collection period of accounts receivable
Formula:
Days in Receivables = 365
Receivable Turnover
Profitability Ratios

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. These are a class of
financial metrics that are used to assess a business's ability to generate earnings.
Below is the list of ratios classified as profitability measures.
1. Gross Profit Margin
 measures the peso value of the gross profit earned for every peso of sales
 expressed as percentage of net sales
 Measures the average markup on products sold (ave.markup-dependent on how
the company controls its cost of goods sold).
Formula:
Gross Profit Margin = Gross Profit

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 Net Sales

2. Operating Profit/Income Margin

 expresses operating income as a percentage of sales
 computed by deducting operating expenses from the gross profit
 measures the percentage of profit
Formula:
Operating Profit Margin = Operating Income/ Operating Profit
Net Sales

3. Net Profit Margin

 or Return on Sales
 measures the peso value of net income earned for every peso of sales
 measures the overall profitability of company
Formula:
Net Profit Margin = Net Income
Net Sales
4. Return on Asset
 measures the profitability of the company’s assets
Formula:
Return on Assets = Net Income
Average Assets

5. Return on Equity
 measures the return generated by the capital invested by the owner in the
business
Formula:
Return on Equity = Net Income
Average Equity

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Solvency and Stability Ratios:
1. Debt to Equity ratio
 Indicates the company’s reliance on debt or liability as a financing source relative
to equity.
Formula:
Debt to equity = Total Debt
Equity
2. Debt ratio
 Indicates the percentage of the company’s assets that are financed by debt.
Formula:
Debt ratio = Total Debt or Total Liabilities
Total Assets

3. Equity ratio
 Indicates the percentage of the company’s assets that are financed by capital.
Formula:
Equity Ratio = Total Equity
Total Assets
4. Interest coverage ratio
 Or Time Interest Earned
 Measures the company’s ability to cover the interest expense on its liability with
its operating income.

Formula:
ICR = Operating Income
Interest Expense

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Activity 1
IDENTIFICATIOn
1. It is one way to assess the liquidity of company by comparing the current assets to
the current liabilities. Current assets
2. It is composed of a numerator and a denominator, which is useful for evaluating a
company’s overall ability to generate cash flows from operating its business. Financial
ratios.
3. It expresses the relationship among selected items of financial statement data. Ratio
analysis.
4. An indicator of the efficiency with which the company is utilizing all of its assets.
Asset turnover ratio.
5. Measures the return generated by the capital invested by the owner in the business.
Return on Equity.

6. Indicates the company’s reliance on debt or liability as a financing source relative to

equity. Debt to Equity ratio
7. It is also called as Return on Sales. Net Profit Margin
8. It is also called as Time Interest Earned. Interest coverage ratio
9. Measure the ability of the company to generate income from the use of its assets and
invested capital as well as control its cost. Profitability ratio.
10. More conservative than current assets. Quick ratio.

Accounting ratios offer quick ways to evaluate a business's financial condition.

According to Accounting Scholar, ratios are the most frequently used accounting
formulas in regard to business analysis. Analyzing your finances with these ratios helps
you identify trends and other data that inform important business decisions.

Here are the most common types of ratios and the various formulas you can use within
each category:

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  Liquidity ratios
 Profitability ratios
 Leverage ratios
 Turnover ratios
 Market value ratios

While it may not be possible to constantly analyze all of these ratios at a given time, it's
crucial to pick a few that are pertinent to your business's operations so you can stay up
to date on what's happening within your company.

Liquidity ratios
These ratios are used to calculate how capable a company is of paying its debts,
usually by measuring current liabilities and liquid assets. This determines how likely it is
that your business will be able to pay off short-term debts. These are some common
liquidity ratios:

 Current Ratio = Current Assets/Current Liabilities: The purpose of this ratio is

to measure if your company can currently pay off short-term debts by liquidating
your assets.

 Quick Ratio = Quick Assets/Current Liabilities: This ratio is similar to the

current ratio above, except that to measure "quick" assets, you only consider
your accounts receivable plus cash plus marketable securities.

 Net Working Capital Ratio = (Current Assets - Current Liabilities)/Total

Assets: By calculating the net working capital ratio, you're calculating the
liquidity of your assets. An increasing net working capital ratio indicates that your
business is investing more in liquid assets than fixed assets.

 Cash Ratio = Cash/Current Liabilities: This ratio tells you how capable your
business is of covering its debts using only cash. No other assets are considered
in this ratio.

 Cash Coverage Ratio = (Earnings Before Interest and Taxes +

Depreciation)/Interest: The cash coverage ratio is similar to the cash ratio, but it
calculates how likely it is that your business can pay interest on its debts.

 Operating Cash Flow Ratio = Operating Cash Flow /Current Liabilities: This
ratio tells you how your current liabilities are covered by cash flow.

Profitability ratios

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Accountants use these ratios to measure a business's earnings versus its expenses.
These are some common profitability ratios:

 Return on Assets = Net Income/Average Total Assets: The return on assets

ratio indicates how much profit businesses make compared to their assets.

 Return on Equity = Net Income/Average Stockholder Equity: This ratio

shows your business's profitability from your stockholders' investments.

 Profit Margin = Net Income/Sales: The profit margin is an easy way to tell how
much of your income comes from sales.

 Earnings Per Share = Net Income/Number of Common Shares

Outstanding: The earnings-per-share ratio is similar to the return-on-equity ratio,
except that this ratio indicates your profitability from the outstanding shares at the
end of a given period

Leverage ratios
A leverage ratio is a good way to easily see how much of your company's capital comes
from debt and how likely it is that your company can meet its financial obligations.
Leverage ratios are similar to liquidity ratios, except that leverage ratios consider your
totals, whereas liquidity ratios focus on your current assets and liabilities.

 Debt-to-Equity Ratio = Total Debt/Total Equity: This ratio measures your

company's leverage by comparing your liabilities, or debts, to your value as
represented by your stockholders' equity.

 Total Debt Ratio = (Total Assets - Total Equity)/Total Assets: Your total debt
ratio is a quick way to see how much of your assets are available because of
debt.

 Long-Term Debt Ratio = Long-Term Debt/(Long-Term Debt + Total Equity):

Similar to the total debt ratio, this formula lets you see your assets available
because of debt for longer than a one-year period.

Turnover ratios
Turnover ratios are used to measure your company's income against its assets. There
are many different types of turnover ratios. Here are some common turnover ratios:

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  Inventory Turnover Ratio = Costs of Goods Sold/Average Inventories: The
inventory turnover rate shows how much inventory you've sold in a year or other
specified period.

 Assets Turnover Ratio = Sales/Average Total Assets: This ratio is a good

indicator of how good your company is at using your assets to produce revenue.

 Accounts Receivable Turnover Ratio = Sales/Average Accounts

Receivable: You can use this ratio to evaluate how quickly your company is able
to collect funds from its customers.

 Accounts Payable Turnover Ratio = Total Supplier Purchases/(Beginning

Accounts Payable + Ending Accounts Payable)/2): This ratio measures the
speed at which a company pays its suppliers.

Market value ratios

Market value ratios deal entirely with stocks and shares. Many investors use these
ratios to determine if your stocks are overpriced or underpriced. These are a couple of
common market value ratios:

 Price-to-Earnings Ratio = Price Per Share/Earnings Per Share. Investors use

the price-to-earnings ratio to see how much they're paying for each dollar earned
per stock.

 Market-to-Book Ratio = Market Value Per Share/Book Value Per Share. This
ratio compares your company's historic accounting value to the value set by the
stock market.

Why look at financial ratios for small business?

Accounting is the language of business. It tells a story. While these formulas may seem
like arcane number crunching, the results are bellwethers of your business's health.

Running a successful business means learning from past mistakes and making healthy
decisions for your future. Without a basic understanding of accounting, you can't plan
for your business's future.

By taking the time to investigate and understand your business's financial health, you
can make accurate decisions about your future and set your business up for success.
For example, total debt ratio can serve as a key indicator of whether it's the right time to
take a new loan. The asset turnover ratio shows how valuable your assets are in
relation to what you're producing. This can inform how you increase business efficiency
or whether you invest in new assets.
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To run a successful business, you must have a clear picture of where you stand at any
given time. Having clear books that are accurate and easy to interpret can ensure you're
running a successful business.

Financial accounting vs. cost accounting

There is a key difference between financial accounting and cost accounting: Financial
accounting addresses the current financial health of a business, while cost accounting
assesses only costs associated with the production of your business. Both can be used
to better understand the financial standing of your company, but cost accounting is
focused on profit and efficiency.

Want to brush up on your basic accounting terms? Check out this infographic.

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