FABM 2 QUARTER 2 LESSON

3
Financial Statement Analysis
(Using Ratio Interpretation)
Most Essential Learning Competency:
The Learner computes and interprets financial
ratios such as current ratio, working capital, gross profit
ratio, net profit ratio, receivable turnover, inventory
turnover, inventory turnover, debt to equity ratio, and the
like. (ABM_FABM12-Ig-h-14)
Objective:
• At the end of the lesson the learner will be able
to:
• A. Provide information that will be helpful in
decision-making.
• B. Compute and interpret financial ratios.
Review:
• 1. What are the 3 importance of financial analysis?
• Confirm past expectations, Evaluate present financial results, and predict future
outcomes.
• 2. It is the process of evaluating risk, performance, financial health, and future
prospect of the business.
• Financial Statement Analysis
• 3. What type of Financial Analysis is also called trend analysis?
• Horizontal Analysis
• 4. It is a type of financial analysis that is called a common size analysis.
• Vertical Analysis
• 5. It is a balance of the current year minus the prior year’s balance.
• Peso Change
What is Ratio Analysis?
Types of Ratio Computation:
• 1. Liquidity Ratio
• 2. Solvency Ratio
• 3. Efficiency Ratio
• 4. Profitability Ratio
Liquidity Ratio:
• Liquidity Ratios determine whether an entity can be able
to pay for the current liabilities as they become due with
the use of Current Assets.
• Computations:

•
 Solve the Following Problem:
(See Financial Statement “Balance
Sheet Sample)
 Current Ratio: Answers the question, can the company
pay for its Current Liabilities with Current Assets?

• Formula:

• Computation:

• Interpretation: In both years, the current assets are larger than the
current liabilities. The entity can pay for its current liabilities using its
current assets since the ratio is greater than 1.
• Remember: CR > 1, the entity can pay CL using CA
• CR=1, CA = CL
• CR < 1, the entity cannot pay CL using CA
QUESTION?
Which of the following statement is correct regarding the current ratio
of Happy Company?
A. Both 2020 & 2019 current ratios are favorable.
B. Both 2020 & 2019 current ratios are unfavorable.
C. 2020 current ratio is favorable and 2019 current ratio is unfavorable.
D. 2020 current ratio is unfavorable and 2019 current ratio is favorable.
Answer: A. Both 2020 & 2019 current ratios are favorable.
Acid Test Ratio: Determine whether the entity is able to pay
current liabilities using Quick Assets.
• Formula:

• Computation:

• Interpretation: Both years show that the entity can pay current liabilities
using quick assets since the ratio is greater than 1.
• Remember: ATR > 1, the entity can pay CL using QA
ATR = 1, QA = CL
ATR < 1, the entity cannot pay CL using QA
QUESTION?
Which of the following year would Happy Company’s quick assets be able to
cover current liabilities?
A. 2020 only.
B. 2019 only.
C. Both 2020 and 2019.
D. Neither 2020 nor 2019.

Answer: C. Both 2020 and 2019.

Cash Ratio: Determines whether the entity is able to pay
current liabilities using cash
• Formula:

• Computation:

• Interpretation: In both years, the entity’s current liabilities are greater

than cash. The entity cannot pay for its current liabilities using its total
cash since the ratio is less than 1.
• Remember * Cash Ratio > 1, Entity can pay CL using total Cash.
* Cash Ratio = 1 , Cash = CL
* Cash Ratio < 1, Entity cannot pay CL using total Cash.
Solvency Ratio:
• Determine whether an entity has more ownership rather than
debts. It is also called leverage ratios. These ratios involve
comparisons of debt such as Assets, equity, and interest.
QUESTION?
Debt Ratio: Answers the question, how many
assets are financed by debts?
• Formula:

• Computations:

• Interpretation:

• Remember:
Debt Ratio:

How will Happy Company express the accounting equation

using assets, debt, and equity percentages for 2020?
A.100% = 18% + 82%
B.100% = 82% + 18%
C.100% = 54% + 46%
D.100% = 46% + 54%

Answer: C. 100% = 54% + 46%

Debt Ratio:

How will Happy Company express the accounting equation

using assets, debt, and equity percentages for 2019?
A.100% = 46% +54%
B.100% = 54% + 46%
C.100% = 65% + 35%
D.100% = 35% + 65%

Answer: C. 100% = 65% + 35%

Debt Ratio:

What is your conclusion?

A.The company is always using debt financing.
B. The company is always using equity financing
C. The company is always using debt financing, but the company is slowly
shifting from debt financing to equity financing.
D.The company is always using equity financing, but the company is slowly
shifting from equity financing to debt financing.

Answer: C. The company is always using debt financing, but the company
is slowly shifting from debt financing to equity financing.
Debt to Equity Ratio: It answers the question, Which has
more weight? Debt or Equity?
• Formula:

• Computation:

• Interpretation: In both years, debt has more weight than equity since
both ratios are greater than 1.
• Remember:
QUESTION?
Which of the following is correct relative to Happy Company’s debt-to-equity ratio
for 2020?
A. The ratio is 1.16, which means the company used more debt financing in that
year.
B. The ratio is 1.16, which means the company used more equity financing in that
year.
C. The ratio is 0.86, which means the company used more debt financing in that
year.
D. The ratio is 0.86, which means the company used more equity financing in that
year.
Answer: A. The ratio is 1.16, which means the company used more debt financing
in that year.
Times Interest Earn Ratio: It answer’s the question, how many
times can an entity pay for interest expense with their operating
income?
• Formula:

• Computation:

• Interpretation:

• Remember:
Efficiency Ratios:
Measures how well the entity utilizes its assets and
resources to generate income.
Asset Turnover Ratio: Answers the question, how
many times can an entity generate sales with their total
asset resources?
• Formula:

• Computation:

• Interpretation: The company’s assets can only generate sales 0.32 times. It is
unfavorable due to its low turnover. The company needs to maximize its sales.

• Remember: The higher the asset turnover ratio, the better. It shows how
the company is able to generate sales from its resources.

• Note: Average Total Assets = total asset 2019 + total asset 2020/2
 Inventory Turnover: Answers the question, how many times can
an entity sell their inventories and have it placed within a period?

• Formula

• Computation

• Interpretation: The company’s inventory turnover is low. It shows weak sales and excess
inventory.

• Remember:

• Note: Average Inventory = Inventory 2019 + inventory 2020/2

Days Sales in Inventory
• How many days does an entity holds on to its inventory before a sales
transaction?
Accounts Receivable Turnover Ratio: Answers the question,
how many times can an entity turn their receivables to cash
for a certain period?
• Formula:

• Computation:

• Interpretation: The company turns receivables into cash 5.20 times over
the whole period. It signals weak collection efforts due to low turnover.
• Remember: A low turnover signals weak collection efforts
• A high turnover signals strong collection efforts.
Note: Average Accounts Receivable = AR 2019 + AR 2020/2
Days in Receivables:
• How many days does an entity wait for a receivable to become cash?
Profitability Ratio:
• Measure how well an entity generates income that relates to its
revenues, operating costs, assets, and capital.
Gross Profit Ratio: Answers the question, how much
gross profit does the company makes after considering
the cost of goods to be sold?
• Formula:

• Computation:

• Interpretation: 59.23% of sales is the entity’s gross profit.

• Remember: Gross profit ratio represents the amount of gross profit for
every P1.00 sale.
Gross Profit Ratio:

Answer: C. P0.59
Return on Assets: Answers the question, how much
income was “returned” using assets to generate profit?
• Formula:

• Computation:

• Interpretation: The entity has 10.63% returns using assets to generate

profit.

• Remember: The higher the returns, the better.

Return on Equity: Answers the question, how much
income was returned using equity to generate profit?
• Formula:

• Computation:

• Interpretation: The entity has 23.00% returns to the shareholder

investments.

• Remember: The higher returns, the better.

Activity:

Based on the given financial statement

report,
base
Compute the following:
1. Profitability Ratio
a. Gross Profit Ratio b. Return on Equity
2. Liquidity Ratio
a. Current Ratio b. Acid Test Ratio
3 Solvency Ratio
a. Debt Ratio b. Debt to Equity Ratio
4. Efficiency Ratio
a. Inventory Turnover Ratio
b. Accounts Receivable Turnover Ratio