Chapter III Financial Statement and Analysis Understanding the Basic Financial Statements Overview on Financial Statement Analysis Horizontal and Vertical Analysis Ratio Analysis 3 Learning Outcomes At the end of the chapter, the learners must be able to: a) identify the various information provided by the basic financial statements; __ 8) appreciate the relevance and importance of financial statement analysis; ©) perform vertical and horizontal methods of financial statement analysis; and 4) compute, analyze and interpret financial ratios in terms of liquidity, solvency, profitability and solvency. _ Understanding the Basic Financial Statements "The Statement of Financial Position The statement of financial position, also called “balance sheet,” is a financial _ “snapshot” of your business at a given date in time. It provides information about _ the financial condition, position and structure of the company in terms of its assets, Habilities, and the difference between the two, which is the equity or net worth. ‘The accounting equation (assets = liabilities + owner's equity) is the basis for the _ statement of financial position or balance sheet. The statement of financial position is usually presented in comparative form. Comparative financial statements include the current year’s statement and statements of one or more of the preceding accounting periods, For example, companies often provide five- or ten-year statements, which make them useful for evaluating and analyzing trends and relationships. Notes added to the statement of financial Position provide additional information not included in the accounts on the financial statements as well as _ =xplanations of figures presented. Moreover, additional information can be _ disclosed by means of supporting schedules or parenthetical notation.Illustrative Example of the Corporation Statement of Financial Position a) Report Form - The statement of financial position can be presented in vertical format known as the report form, with the Assets Section above the Liabilities and Equities sections that, together, balance it.: . Goes y Form — The entire statement of financial position is normall 4 cased lig elcedlleyoct wit BAsets ge at ater ee en Liabilities and Equities on the right. This is known as the Account Form. Sicaas hacalvabh ne ! | Statement of Comprehensive Income In the context of corporate financial reporting, the income statement summarizes a company’s revenues (sales) and expenses quarterly and annually for its fiscal year. The final net figure, as well as various others in this statement, is of major interest to the investment community as it Tepresents the company’s financial performance for the current year. Income statements come with various monikers. The most commonly used are “statement of income,” “statement of earnings,” “statement of operations” and “statement of operating results.” Many professionals still use the term “P&L,”which stands for profit and loss statement, but this term is seldom found in print these days. In addition, the terms “profits,” “earnings” and “income” all mean the same thing and are used interchangeably. Forms and Presentation of the Statement of Comprehensive Income a) Multi-Step Approach — The statement of comprehensive income using the multi-step approach shows the various profitability stages from gross profit, operating profit up to the net profit which is essential in terms of cost control and management. DP Company Income Statement 31-Dec-2017 (in thousand P ) Sales 785,000 Less : Sales Discount (16,500) ‘Sales Return & Allowances (53,200) 715,300 Less : Cost of Goods Manufactured & Sold 335,000 Gross Profit 380,300 Less: Selling and Administrative Expenses Selling Expenses 133,000 % ‘Administrative Expenses Net Operating Profit 82,300 Less : Interest Expense Net Profit Before Tax 70,300 Less : Income Taxes (30%) 21,090 Net Profit after Tax 49.210 Supporting Statement : Cost of Goods Manufactured and Sold Direct Materials Raw materials inventory beginning 125,000 + Raw Materials Purchases is Total Materials Available 350.000 sw 215,000 135,000 it rr ¥ Factory Overhead 92,000, Total Manufacturing Cost ee ‘Add : Work In Process, beginning se Total goods placed in process oe Less; Work in process, end 530,000 Total Cost of Goods Manufactured 4 Add: Finished Goods , beginning . 000 Total Goods Available for Sale ee Less: Finished Goods, end es ‘Cost of Goods Sold =aeeee 3 42b) Single Step Approach ~ The service type of statement of comprehensive income was shown using a single step approach as it simply identifies the income that comes from professional fee and all expenses grouped together to arrive to a net profit. ADP Tax & Accounting Services Income Statement 31-Dec-2017 (in thousand P ) Professional Fee 27,500 Less: Operating Expenses Office Supplies 21,650 Depreciation E 10,000 Rent 12,000 Salaries 48,000 __91,650 Net Profit Before Taxes 135,850 Less : Income Taxes (30%) Net Profit After Tax 95,095 Statement of Changes in Equity A statement of changes in equity shows all changes in owner's equity for a period of time. According to Philippine Accounting Standard #1 (PAS 1), this statement of financial reporting is one the five components of complete financial statements (statement of financial position, income statement, statement of changes in equity, statement of cash flow and notes to financial statements). The purpose of the statement of changes in equity is to provide readers with the useful information on how the capital or fund of an entity is utilized and used, Since it shows the movements of equity and accumulated earnings and losses, the readers can depict on where the company’s equity came from and where did it go. Illustrative Example of the Statement of Changes in EquityOverview of Financial Statement Analysis Financial statement analysis is the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the income statement account. ‘There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios Uses of Financial Statement Analysis Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. What can you look for when reading financial statement analysis report and how do you use it ? ‘Trends — The results given in generally cover at least the previous three full accounting years therefore any fluctuations in any area can be easily pinpointed Benchmarks — The average results for each ratio together with the industry profile of the average company in the sector can both be used as benchmarks to compare individual company performance. Size — All the major companies in the sector are ranked on the basis of sales, Profits, total assets and employee numbers (PERFORMANCE LEAGUE TABLES — Section 4). The largest and smallest of the key players can be easi identified, while the relative size of any company ae Games ‘eer Growth ~ The average annual growth of each company’s sales, profits, total assets and number of employ iod bei assets and number of employees over the three-year period being analyzed is This key information highlights trong and weak performers, which companies are expanding or losing market share, increasing or decreasing asset investment, or taking on or shedding employees. The industry results are also given for iparison purposes. This information i i Te per is perfect for all kinds of planning and Competitor Analysis — The depth of financial anal i : ided empty Ani The eth fanaa vied om nh performance of individual businesses over recent years. The performance ratios Jetyou easily identify the financial strengths and weaknesses of competitors in terms of profitability, liquidity, gearing, efficiency and employee performanceSimple Benchmarking - You can choose to benchmark your company against a major competitor, or assess the overall industry average performance. ‘And you can focus on the criteria that are important to your business, such as profitability, employee performance or sales growth. Setting realistic performance targets becomes easier for you; with ratio reports, you will know that they are based on solid facts about your industry. ‘Tracking Performance Trends - With at least three years of financial data for each company and the entire industry, you can identify performance trends instantly. Identifying Acquisition Targets - Ratio reports make it simple for you to identify potential acquisitions. Advantages of Financial Statement Analysis There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis. Limitations of Financial Statement Analysis: 4 Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. a) Comparison of Financial Data Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies’ financial data. For example if one firm values its inventories by LIFO method and another firm by the average cost method, then direct comparison of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading. Sometimes enough data are presented in footnotes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry average often suggest avenues for further investigation.b) The Need to Look Beyond Ratios ‘An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment about the future. Nothing could be further from the truth. Conclusions based on ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any question by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgment about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimization about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre. Tools and Techniques of Financial Statement Analysis Horizontal Analysis or Trend Analysis: Comparison of two or more year’s financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both peso and percentage form. Illustrative Example 1- Horizontal Analysis EJS Resort Corporation Comparative Statement of Financial Position December 31, 2018 and 2017 (in thousand P) Horizontal Analysis 2018 2017 Inc (Dec) % Assets Current Assets Cash 600 1,175 (575) -48,94% ‘Accounts Receivable,net 3,000 2,000 1,000 50.00% Inventory 4,000 5,000 (1,000) 20.00% Prepaid Expenses ——150______60_90 10.00% Total Current Assets ——1150____8235 __(azs) 5.20% ‘Non Current Assets Land 2,000 2,000 = 0.00%Buildings , net Equipment, net Furniture & Fixtures, net Total Non Current Assets Total Assets Liabilities and Stockholders Equity Current Liabilities Accounts Payable Accrued Payable Notes Payable, short term Total Current Liabilities ~ Non Current Liabilities Mortgage Payable Bonds Payable , 5% Total Non Current Liabilities Total Liabilities Stockholders Equity Preferred Stock , P100, 6% Common Sock , P12 par Additional Paid In Capital Total Paid In Capital Retained Earnings Total Stockholders Equity Total Liabilities and Stockholders Equity 3,000 2,500 500 20.00% 2,000 1,000 1,000 100.00% 1000 pa i on ane 8000 6.250 _1,750___28.00% issn t4ags 26s rate 2,900 2,000 900 45.00% 450 200 250 125.00% ———_1s0______300 ____150)__=50.00% 3,500 __2,500__1,000 __40.00% 2,750 2,000 750 37.50% 1,000 1,000 - 0.00% 3,000 3,000 - 0.00% - 500 500 0.00% 4,500 4,500 - 0.00% ——4,000_____3,485___sis___ 14.72% ——A4,500____7.985__s15__6.45%_ ——15.250____14,485__1265_g.73% The above shows the changes in 2018 and 2017 by comparing both years. For example Cash, we compute the change by Cash in 2018 less Cash in 2017 = P600 ~P1,175 = (P575). Then , the amount of (P575) is divided to P1,175 = (48.94%). The same formula is to be followed for all assets, liabilities and stockholders equity account. This is also the same formula to follow in doing the horizontal analysis for the Income Statement as shown below: a7Illustrative Example 2 : Horizontal Analysis EJS Resort Corporation Comparative Income Statement December 31, 2018 and 2017 (in thousand P) Horizontal Analysis 2018 2017 Inc (Dec) % Sales, net 26,000 - 24,000 2,000 8% aus 8,000 8,250 (250) -3.03% Less: Selling and Administrative Expenses Selling Expenses 3,500 3,250 250 7.69% Administrative Expenses 2.930 3,050 an). 93% Total S & A Expenses ——6.430__6300 132.06 % ‘Net Operating Income 1570 1,950 (380) -19.49% Less: Interest Expense Net Income Before Taxes 1,250 1,600 (B50) -21.88% Less: Income Taxes (35%) e Net Income ——#75 __1,120_(245)__-21.88% Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years’ financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. To illustrate, let us look at the summary of EJS Resort Company sales and net income from 2013 to 2018: Sales and Net Income in Peso 2013 2014 2015 2016 2017 2018 a 18,000 19600 21000 24,300 26,000 24,000 Income 535 665 715 795 875 1,120 The data below show sal id net i i is is cancun les an income in percentages and this is Base Year = 2013 = P18,000 = 100% for sales and P535 = 100% for net income.Using the base year, we compute for the succeeding years as: Sales ‘Net income 2014 = P19,600 / 18,000 = 109% P665 / 535 = 124% 2015 = P21,000 / 18,000 = 117% P715 / 535 = 134% 2016 = P24,300 / 18,000 = 135% P795 / 535 = 149% 2017 = P26,000 / 18,000 = 144% P875 / 535 = 164% 2018 = P24,000 / 18,000 = 133 % P1,120 / 535 = 209% Sales and Net Income in Percentage 2013-2014 «2015. 2016. =~ 2017 pales 100% 109% 117% 135% 144% Income - 100% 124% 134% «© 149% + 164% Sales Trend Percentages Chart 160% ‘40% 120% 0% Net income Trend Percentages Chart Fee elnino eee 250% 20% j= p™ om m% 2018 133% 209% 49Vertical Analysis: Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in peso form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. Illustrative Example 1: Common Size Comparative Balance Sheet EJS Resort Corporation Common Size Comparative Statement of Financial Position December 31, 2018 and 2017 in thousand P ) Common Size % 2018 2017 2009 2010 Assets: Current Assets Cash 600 1175 3.81% 8.11% Accounts Receivable, net 3,000 2,000 19.05% 13.81% Inventory 4,000 5,000 25.40% 34.52% Prepaid Expenses 8 ap a haa in Total Current Assets —_1.150__8.235 49.21% 56.85% ‘Non Current Assets Land 2,000 2,000 12.70% 13.81% Buildings, net 3,000 2,500 19.05% 17.26% Equipment, net 2,000 4,000, 12.70% 6.90% Furniture & Fixtures, net ——Lono_750 6.35% 5.18% Total Non Current Assets ——#,000__6,250__50.79% _43.15% _ Total Assets ——15,250____14,485_100.00% __100,00%_ Liabilities and Stockholders Equity (Current Liabilities Accounts Payable 2,900 2,000 18.41% 13.81% Accrued Payable 450 200 2.86% 1.38% Notes Payable, short term 50 300 0.95% 2.07% Total Current Liabilities 3.500 2.500 22.22% 17.26% Non-Current Liabilities * Mortgage Payable 2,750 2,000 17.46% 13.81% Bonds Payable, 5% 000 2,000 635% 381% ‘Total Non-Current Liabilities —— 4,000 23.81% 27.61% Total Liabilities 7.250 6500 46.03% 44.879 50Stockholders Equity . i Preferred 3 P100, 6% 1,000 1,000 6.35% 6.90% 19.05% 20.71% ‘Common Sock, P12 par 3,000 3,000 Additional Paid In Capital 500 500 3.17% 3.45% Total Paid In Capital 4,500 4,500 28.57% 31.07% Retained Earnings . 4.000 1.485 __25.40% 24.0644 ‘Total Stockholders Equity ——8,500____7,9R5__53.97% __ 55.13% ‘Total Liabilities and ‘Stockholders Equity 15,750 _14,485__100.00% _100.00% _ Please note that the figures of each asset account expressed in percentages is computed as : Each asset item /total assets, which for example Cash in 2018 = P600/P15,750 =3.81% The same is true with the liabilities and stockholders equity account expressed in percentage : Each liability & stockholders equity accounts /total liabilities which if we take Accounts Payable in 2018 = P 2,900/P15,750 = 18.41% and for Retained Earnings in 2018 = P4,000/P15,750 = 25.40%. Based on the above illustrative example, you can observe significant changes in current assets in 2018 compared to 2017. For example, accounts receivable increased while cash and inventory decreased. The company now can take a closer look what happened and might found out that there could be some difficulty in collecting payment from customers. : In the case of the non-current assets, the decrease is brought by the increase in depreciation (tear & wear cost) of building, equipment and furniture & fixtures affecting their book value as shown in the example. Since the total of the non- Current assets is reduced, thus land account also gets affected but shows an increase in percentage even if the peso value remains constant. Looking at our current liabilities, both accounts and accrued payable decreased whilenotes payable increased. This can also bea factor in our cash balance decrease since we made payment to our creditors. The notes payable can be attributed that the company probably opted to issue promissory notes for some of its purchases, ‘The same is true with non-current assets, where the company mortgage payable decreases since payment had been made while bonds payable incrtseos because the company opted to borrow from creditor in the form of bonds, Nothing can be said on the stockholders’ equity section since only the retained pale ae suited toa decrease which we could attribute that probably the company Paid some dividends. Overall, the year 2018 is a much better year for the company based on the above comparative statement and if we are to look at the percentages. However, it is important to go deeper before arriving to a final conclusion. 51Illustrative Example 2: Common Size Comparative Income Statement EJS Resort Corporation ‘Common Size Comparative Income Statement December 31, 2018 and 2017 (in thousand P) Common Size % 2018 201720182017 Sales, net 26,000- 24,000 100% += :100% 7 ——18.000_15.750 69.23% 65.63% Cosine 8,000 8.250 30.77% 34.38% Less: Selling and Administrative : Expenses Selling Expenses 3,500 3250 13.46% 13.54% Administrative Expenses 2.930 _3,050 11.27% 12.71% Total S & A Expenses ——6.420__6,300 24.73% 26.25% ‘Net Operating Income 1,570 1950 6.04% 8.13% Less: Interest Expense ek aan ap aaa ee Net Income Before Taxes 1,250 1,600 4.81% 6.67% Less: Income Taxes (35%) ———_15__480._1.44% 2.00% Net Income ———85____120.___3.357%_4.67%_ In the income statement, the basis of the percentage figure is the net sales. For example, cost of good sold percentage is computed as: cost of good sold /net sales = P18,000/P26,000 = 69.23%. Thus in income statement, each account item is divided over the net sales to get the percentage figure. In the example above, we can see that net income in 2017 (4.47%) is better than in 2018 (3.37 %). Ratio Analysis The ratios analysis is the most powerful tool of financial statement analysis, Ratio simply means one number expressed in terms of another, A ratio is « statistical yardstick by means of which relationship between two or various Gan be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show haw one number is related to another. 1. Profitability Ratios Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm, Some profitability ratios are as under: ee mo Boel a. Gross profit ratio Formula: Gross Profit Ratio = (Gross profit/Net sales) x 100] Example: : Total sales = P260,000; Sales retums = P10,000; Cost of goods sold P200,000 52Calculation: Gross profit = [(260,000 — 10,000) ~ 200,000] = 50,000 Gross Profit Ratio = (50,000/250,000) x 100 = 20% Significance: Gross profit ratio reflects efficiency with which a firm produces its products. As the gross profit is found by deducting cost of goods sold from net sales, the higher the gross profit, the better it is. There is no standard GP ratio and it varies from business to business. However, the gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges and dividends. Net profit ratio Formula: Net Profit Ratio = (Net profit/Net sales) x 100 Example: Using same example above except that net profit is P20,000 Calculation: Net sales = (260,000 — 10,000) = 250,000 Net Profit Ratio = [(20,000/250,000) x 100] = 8% Significance: This ratio measures the overall profitability and very useful to proprietors or owners of the company. This ratio also indicates the firm’s capacity to face adverse economic conditions such as price competition, low demand, and similar situations. The higher the ratio the better is the profitability. Operating ratio Formula: rating Ratio = [(Cost of, sold i Nema) on Ke eee area Example: Cost of goods sold is P90,000 and other i Cost of goods sold iF operating expenses are P15,000 Calculation: Operating ratio = [( 90,000 + 15,000)/150,000] x 100 = [115,000/150,000] x Significance: Operating ratio shows the operational efficiency of the business, Lower operating ratio shows higher operating profit and vice versa. An operating ratio ranging between 75% and 80% is generally considered as standard for manufacturing concerns. This ratio is considered to be a yardstick of operating efficiency but it should be used cautiously because it may be affected bi umber of Foceisel o€ he Bats yam uncontrollable factors beyond the 53d. Return on shareholders investment or net worth Formula: Return on shareholder’s investment = [Net profit (after interest and tax) / Shareholder’s fund] x 100 Example: Suppose net income in an organization is P30,000 where as shareholder's investments or funds are P200,000. Calculation: Return on share holders investment = (30,000/200,000) x 100 =15% This means that the return on shareholders funds is 15 centavos per peso. Significance: This ratio is one of the most important ratios used for measuring the overall efficiency of a firm. This ratio is of great importance to the present and prospective shareholders as well as the management of the company. The ratio reveals how well the resources of the firm are being used and the higher the ratio, the better are the results. Return on equity capital - Formula of return on equity capital ratio is: Return on Equity Capital = (Net profit after tax — Preference dividend) / Equity share capital] x 100 . Example: Equity share capital (P50): P500,000; 9% Preference share ‘capital: P250,000; Taxation rate: 35% of net profit; Net profit before tax: P200,000. 2 Calculation: Return on Equity Capital NEC) ratio = +m sit Saieseatwhes (ROEC) ratio = [(200,000 — 70,000 - 22,500)/ Seine __,_. This ratio is more meaningful to the equity shareholders who interested to know profits earned by the company and those profits which cae a eae pay dividends to them. The ratio is similar to the ion of return on shareh« investm: higher eaisenapenentes jolder’s investments and the the f. Dividend yield ratio F : Divi i io = Divi ae Dividend Yield Ratio = Dividend Per Share/Market Value PerExample: Ifa company declares dividend at 10% on its shares, each having a paid up value of P4.00 and market value of P12.50. Calculation: Dividend Per Share = (10 (%.n shares)/100 ) x 4 = P0.40 Dividend Yield Ratio = (P0.40/12.50) x.100 = 3% Significance of the Ratio: This ratio helps as intending investor is knowing the effective return he is going to get on the proposed investment. Once again, the higher the ratio, the better. . Dividend payout ratio Formula: Dividend Payout Ratio = Dividend per Equity Share/Earnings perShare Acomplementary of this ratio is retained earnings ratio. Retained Earning Ratio = Retained Earning Per Equity Share/Earning Per Equity Share Example: Net Profit 5,000 No. of equity shares 1,500 Provision for taxation 2,500 ‘Dividend per equity share -P.0.25 Preference dividend 1,000 Payout Ratio = (P0.25/P1) x 100 = 25% Retained Earnings Ratio = (P0.75/P1) x 100 = 75% Significance of the Ratio: The payout ratio and the retained earning ratio are the indicators of the amount of earings that have been ploughed back in the busines A lower payout ratio or higher retained ings ratio tr financial position ofthecompany. nee Earnings Per Share (EPS) Ratio a Formula: Earnings per share (EPS) Ratio = (Net profit after tax—Preferenc dividend)/No. of equity shares (common shares). ae Example: Equity share capital (P100): P1,000,000; 9% Preference share capital: 500,000; Taxation rate: 35% of net profit; Net profit before tae PAUG Gar - Calculation: ae ee )/(P1,000,000/100) = P255,000/10,000Significance: 3 The earnings per share is a good measure of profitability and when compared with EPS of similar companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio calculated for a number of years indicates whether or not the earning power of the company has increased. Price earning ratio Formula: Price Earnings Ratio = Market price per equity share/Earnings per share Example: ‘The market price of a share is P15 and earning per share is P3. Calculation: ; Price earnings ratio= P15/P3 = P5 The market value of every one peso earned is five times or P5. Significance of Price Earning Ratio: Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a particular company at a particular market price. - Generally, higher the price earning ratio the better it is. If the P/E ratio falls, the management should look into the causes that have resulted into the fall of this ratio. 2. Liquidity Ratios Liquidity ratios measure the short-term solvency of financial position of a firm. These ratios are calculated to comment upon the short-term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most imiportant liquidity ratios. Current ratio Formula: Current Ratio = Current Assets /Current Liabilities Example: Current assets are P600,000 and total current liabilities are P300,000. Calculation: : Current Ratio = P600,000/P 300,000 = 2:1 Significance: This ratio is a general and quick measure of liquidity of a firm. It i an index of the firms financial stability, technical See ieee ch of working capital. A high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time and when they become due. A ratio equal to or near 2: 1 is considered as a standard .or normal or satisfactory. The idea of having double the current assets as compared to current liabilities is to provide for the delays and losses in the realization of current assets. Liquid / Acid test / Quick ratio Formula: [Liquid Ratio = Liquid Assets /Current Liabilities] Example: Cash P90; Accounts Receivable P730; Inventory P900; Marketable Securities P800 Accounts Payable P350; Notes Payable P500; Accrued Expenses P75; Tax payable P550. Liquid Assets = P90 + P730 +P 800 = P1,620 Current Liabilities = P350 + P500 + P75 + P550 = P1475 Liquid Ratio = P1,620/1,475 = 1.10:1 Significance: The quick ratio/acid test ratio measures the firm’s capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is more rigorous test of liquidity than the current ratio because it eliminates inventories and prepaid expenses as a part of current assets. Usually a high liquid ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand, a low liquidity ratio represents that the firm’s liquidity position is not good. Asa convention, generally, a quick ratio of “one to one” (1:1) is considered to be satisfactory. 3. Activity Ratios Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned into sales. Following are the most important activity ratios: En a. Inventory turnover ratio Formula of Inventory Turno' Ratio: Cost ee ry ver Cost of Goods Sold /Average Example: The cost of goods sold is P300,000. The beginning i ‘4 aol ee On beginning inventory is P50,000 37Calculation: Inventory Turnover Ratio (TR) = P300,000/{(50,000 + 90,000)/2} = 4.29 times This means that an average one peso invested in inventory will turn into 4.29 times in sales. Significance: Inventory turnover ratio measures the velocity of conversion of inventory into sales. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. : Debtors/Receivables turnover ratio Formula of Debtors Turnover Ratio: Net Credit Sales / Average Trade Receivables Example: Credit sales P250,000; Sales Returns P10,000; Trade Receivables, beginning 35,000 and Trade Receivables, ending, P55,000 Calculation: Receivable Turnover = {P250,000- 10,000}/{{P35,000 + P55,000} /2] = P240,000/45,000 = 5.33 times Significance of the Ratio: ‘Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times the debtors are turned over a year. The higher the value of debtors turnover the more efficient is the management of debtors or more liquid the debtors are. . Average collection period Formula of Average Collection Period: 360 days /Receivable Turnover Example: eae the example in receivable turnover which gives a result of 5.33 Calculation: 360 days/5.33 times = 67.5 days or 68 days Significance of the Ratio: ___ This ratio measures the quality of debtors. A short collection period implies prompt payment by debtors. It reduces the chances of bad debts. eras) longer collection period implies too liberal and inefficient it collection performance. It is difficult to provid i ees providea standard collectionc. Creditors/Payable turnover ratio Formula: Creditors /Payable Turnover Ratio = Net Credit Purchase /Average Trade Creditors Average Payment Period: Average payment period ratio gives the average credit period enjoyed from the creditors. It can be calculated using the following formula: Average Payment Period = 360 days/Payable Turnover ratio Example: Purchases 450,000, Purchase Returns P35,000, Accounts Payable beginning P65,000 and Accounts Payable ending P85,000 Calculation: Payable Turnover Ratio = {P450,000 — P35,000}/[{ P65,000 + P85,000}/2] = P415,000/P 75,000 = 5.53 times Average Payment Period = 360 days/5.53 times = 65 days Significance of the Ratio: The average payment period ratio represents the number of days by the firm to pay its creditors. A high creditors turnover ratio or a lower credit period ratio signifies that the creditors are being paid promptly. This situation enhances the credit worthiness of the company. However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors. . Working capital turnover ratio Formula of Working Capital Turnover Ratio: Working Capital Turnover Ratio = Cost of Sales /Net Working Capital Example: Cash 5,000 Accounts Receivables 2,000 Notes Receivables 15,000 Inventory 10,000 Accounts Payable ' 25,000 Cost of sales 125,000 Calculation: Working Capital Turnover Ratio = Cost of Sales /Net Working Capital Current Assets = P25,000 + P2,000 + P45,000 + P10,000 = Doe ze Current Liabilities = P45,000 Net Working Capital = Current assets — C liabilities = ea psn LB an ‘urrent liabilities aes Working Capital Turnover Ratio = 165,000/37,000 = 4.46 timesSignificance: The working capital turnover ratio measure the efficiency with which the working capital is being used by a firm. A high ratio indicates efficient utilization of working capital anda low ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack of sufficient working capital which is not a good situation. e. Fixed assets turnover ratio Formula: Fixed Assets Turnover Ratio = Cost of Sales/Net Fixed Assets Example: Land P1,200,000; Building (net) P 550,000; Equipment (net) 350,000; Cost of Sales P365,000 Calculation: (P1,200,000 + P550,000 + P350,000} /P365,000 = P2,100,000/ 365,000 = 5.75 times Significance: Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures the efficiency and profit earning capacity of the concern. The higher the ratio, the greater is the intensive utilization of fixed assets. Lower ratio means under-utilization of fixed assets. 4, Long-Term Solvency or Leverage Ratios Long-term solvency or leverage ratio conveys a firm’s ability to meet the interest costs and payment schedules of its long-term obligations. Following are some of the most important long term solvency or leverage ratios. a. Debt-to-equity ratio Formula of Debt to Equity Ratio: Total Liabilities /Total Shareholders Equity Example: From the following figures calculate debt to equity ratio: Equity share capital 750,000 Capital reserve 250,000 Retained Earnings 100, Bonds Payable zo000 Mortgage Payable 120,000 Accounts Payable 200,000 Calculation: Total Liabilities = P300,000 + P120,000 + 200,000 Pe x y ,000 = P620,000 Shareholders’ Equity = P750,000 + P250, A P620,000/P 1,100,000 = .56:1 ee Oe Significance of Debt to Equity Ratio: Debt to equity ratio indicates the i ims of owners 1 proportionate claims of the outsiders against the firms assets. The purpose is to get an ides af hecushion available to outsiders on the liquidation of the firm. The owners want to do the business with maximum of outsider’s funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owners’ interests are greater than that of creditors, the financial position is highly solvent. |. Proprietary or Equity ratio Formula: Proprietary or Equity Ratio = Shareholders Equity/Total Assets Example: Let us use the example above, except that the total asset is P2,500,000. Calculation: - Proprietary or Equity Ratio = P1,100,000/P2,500,000 = 44 :1 Significance: This ratio throws light on the general financial strength of the company. The higher the ratio or the share of shareholders in the total capital of the company, the better is the long-term solvency position of the company. A low proprietary ratio will include greater risk to the creditors. This ratio may be further analyzed into the following two ratios: 1. Ratio of fixed assets to shareholders’/proprietors’ funds Formula: é Fixed Assets to Proprietors’ Fund = Fixed Assets/Proprietors’ Fund The fixed assets are considered at their book value and the proprietors’ funds consist of the same items as internal equities in the case of debt equity ratio. Example: Suppose the depreciated book value of fixed assets is P18,000 and Proprietors’ funds are 24,000 the relevant ratio would be calculated as follows: Fixed assets to proprietors’ fund = 18,000/24,000 = 0.75 or 0.75:1 Significance: . The ratio of fixed assets tonet worth indicates the extent to whi shareholders’ funds are sunk into the fixed assets. eet te purchase of fixed assets should be financed by shareholders’ equity including reserves, surpluses and retained earnings. If the ratio is less than 100%, it implies that owners’ funds are more than fixed assets and a part of the working capital is provideby the shareholders. When the ratio is more than the 100%, it implies that owners’ funds are not 61sufficient to finance the fixed assets and the firm has to depend upon outsiders to finance the fixed assets, .. Ratio of current assets to shareholders/proprietors’ funds Formula: Current Assets to Proprietors’ Funds = Current Assets/Proprietor’s Funds Example: This may be expressed either as a percentage, or as a proportion. To ilustrate, ifthe value of currentassets is PI3,000 and the proprietors’ funds are P90,000 the relevant ratio would be calculated as follows: Current Assets to Proprietors’ Funds = P13,000/P90,000 = .14 or 14% Significance: Different industries have different norms and therefore, this ratio should be studied carefully taking the history of industrial concern into consideration before relying too much on this ratio.