Unit 5: Interpreting and Analyzing Financial Statements

Lesson 5.3
Financial Ratios
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 5

Financial Ratios 5
Definition 6
Uses and Purpose 6
Liquidity Ratios 7
Current Ratio 8
Working Capital 9
Profitability Ratios 10
Gross Profit Ratio 10
Net Profit Ratio 12
E ciency Ratios 13
Accounts Receivable Turnover 13
Inventory Turnover 15
Solvency Ratios 17
Debt-to-Equity Ratio 18
Applying Financial Ratios in Business 19

Case Study 20

Keep in Mind 21

Try This 23

Practice Your Skills 24

Challenge Yourself 27

Bibliography 29
Unit 5: Interpreting and Analyzing Financial Statements

Lesson 5.3

Financial Ratios

Introduction

It may not be enough to say that a company is in good or bad financial condition and
performance simply by comparing factors based on previous periods or with other
companies. It would be more helpful to assign a quantifiable measurement to determine
the "condition" or "performance" to arrive at a more accurate description of the company's
situation.

In this lesson, you will learn that performing a simple arithmetic operation in the form of
division can be utilized to measure a business's condition and performance. The calculation,
however, is the easier part. More critical in helping the company grow is learning how to
interpret and use these mathematical data to make sound and timely decisions.

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Unit 5: Interpreting and Analyzing Financial Statements

Learning Objectives DepEd Competency

At the end of this lesson, you should be able to Compute and interpret financial ratios such as
do the following: current ratio, working capital, gross profit ratio,
net profit ratio, receivable turnover, inventory
● Define financial ratios.
turnover, debt-to-equity ratio, and the like
● Perform financial ratio computations.
(ABM_FABM12-Ig-h-14).
● Interpret the results of the financial ratio
computations.

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Quick Look

My Task Completion
Assume that your teacher gave you a task. The task involves gathering online responses
from 10 business owners. You have already gathered several responses. Now, you want to
know what percentage of this task you have accomplished.

Online Responses Gathered

Particulars Responses

Target responses for the task 10

Responses gathered:
Mikee’s Laundry 1
Mark’s Furniture 1
Ally’s Bakeshop 1
Tony Chopper Associates 1
Mirko’s Fine Dining 1
Midoriya’s School Supplies 1
Emil’s Grocery Store 1
Total number of responses gathered 7

Lacking responses 3

Percent Completion

Percentage completion 70%

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The table shows that you have already accomplished 70% of the task requirements. It
means that 30% of the task is still incomplete.

Just like these calculations, financial ratios allow you to define a particular quantity by using
another quantity as a basis of measurement or assessment.

Questions to Ponder
1. What is the main factor affecting your completion rate of the required task?
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

2. Is presenting your accomplishment in terms of percentage better than showing the

raw values and quantities? Explain your answer.
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

3. How will you use the results of your computation to help you accomplish your task?
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

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Unit 5: Interpreting and Analyzing Financial Statements

Learn the Basics

Financial ratios are a beneficial approach to determining, evaluating, and comparing a

business's economic situation and overall performance. An analyst can use ratio analysis to
identify trends in a business's economic performance and to compare its overall
performance and financial situation to the average overall performance of comparable
groups in the same industry.

Financial analysts use ratios to identify a business's progress, discover developments, and
address potential areas of concern. Financial ratio evaluation can be used to answer
questions such as:
● Is the enterprise profitable?
● Can the enterprise pay its financial obligations on time?
● How is the enterprise financed?

Banks and lenders also use financial ratio evaluation to help them determine whether or
not a company is a good credit risk.

Essential Question
How can the company use financial ratios in making business decisions?

Financial Ratios
Financial ratios are generated from the figures presented in financial statements. A
quantitative analysis is performed on these figures to draw a more comprehensible
understanding of the company’s overall condition and performance.

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Unit 5: Interpreting and Analyzing Financial Statements

Definition
Financial ratio analysis, also known as ratio analysis, is a quantitative way to gain insights
into various parameters that the company may use to measure different performance levels
(Jonick 2018). Financial ratios can be categorized into major groups: liquidity ratios,
profitability ratios, activity ratios, and solvency ratios.

Figure 1. Categories of financial ratios

Uses and Purpose

Analyzing financial ratios is an effective way to assess a company's performance
quantitatively. It provides companies with metrics to determine how good (or bad) they
perform in a particular period. Ultimately, accomplishing these analyses aims to gain a
clearer picture of the situation, identify problem areas, measure the attainment of
objectives, and perform corrective actions when necessary.

Ratio analysis provides insights into the company's financial position, liquidity, profitability,
risk, solvency, operational efficiency, and proper use of funds. It also shows trends or
comparisons to aid decision-making.

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It is important to note that generating numbers, no matter how accurate, does not
necessarily equate to desirable results for the company. How these numbers are
interpreted and used to guide actions is of paramount importance. Table 1 presents the
primary uses of financial ratios.

Table 1. Uses of financial ratios

Usage Brief Description

Tracking Performance Individual financial indicators are determined on a

period-by-period basis to identify business performance trends.
For example, an increase in the ratio of liabilities to assets may
indicate that a company may be overloaded with liabilities and
exposed to default risk.

Decision Making It is important to compare financial measurements with those

of major competitors to determine if a company's performance
is better or worse than the industry average. For example,
comparing returns on investment between companies can help
analysts or investors decide which companies are using their
assets more efficiently.

Liquidity Ratios
The liquidity ratio is a type of financial ratio used to determine a company's ability to repay
current liabilities. Creditors and investors use liquidity ratios to measure business
performance. The most commonly used liquidity ratios are the current ratio and working
capital measurement.

Given the ratio structure, with assets on top and liabilities on the bottom, ratios above 1.0
generally indicate liquidity.

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Current Ratio
The current ratio is a liquidity ratio that measures a company's ability to pay short-term
obligations or those due within one year. It tells investors and analysts how a company can
maximize the current assets on its balance sheet to satisfy currently maturing obligations.

Current ratios above the industry average are generally considered favorable. A current
ratio below the industry average may indicate a high risk of inability to pay current payables.
On the other hand, companies with a very high liquidity ratio compared to their peers may
suggest that management may not be using their assets efficiently. For example, a very high
liquidity ratio could mean that the company is not making good use of available cash for
business expansion or improvement of business operations. Since the current ratio
measures the company's current assets, it is also known as its working capital ratio.

The current ratio formula is shown below:

The following table summarizes how the values generated from the current ratio may be
interpreted.

Table 2. Current ratio values

Current Ratio Brief Description

Current Ratio = 1 It means that the current assets are equal to current liabilities
and can precisely cover current liabilities as their value shows.

Current Ratio > 1 It means that the current assets are more than the current
liabilities. A portion of the current assets will remain after
paying all current liabilities.

Current Ratio < 1 It shows that the current assets are insufficient to cover the
current liabilities.

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Closer Look

Calculating and Interpreting Current Ratio

Assume that your balance sheet shows current assets amounting to
₱34,500 and current liabilities totaling ₱24,900. Applying the formula
above, you can calculate the current ratio as follows:

Using your current assets alone to pay off all outstanding current

liabilities as currently presented on your balance sheet, your existing
assets can cover them over 1.39 times.

Working Capital
Working capital is the resulting figure after deducting current liabilities from current assets
(Hermanson, Edwards, and Maher 1989). It serves as an indicator of a company's liquidity,
operational efficiency, and short-term financial position. The formula for working capital is:

If a company has positive working capital, it has the potential to invest and grow. On the
other hand, if its current assets do not exceed its current liabilities, it may have difficulties
repaying its creditors and funding growth.

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Closer Look

Calculating and Interpreting the Working Capital

Continuing with the previous example and applying the working capital
formula, the calculations will result in the following value:

Since the resulting figure is positive, your working capital is sufficient to

fund current operations and has room for future investments.

Profitability Ratios
Profitability ratios are a class of financial ratios used to assess a company's ability to
generate revenue relative to its income, operating expenses, balance sheet assets, or
equity-related accounts using data at a particular time. Analysts can compare profitability to
efficiency measures because it considers how well a company uses its assets internally to
generate revenue.

Profitability figures are usually compared with the ratio of competitors or with the ratio in
the previous period to indicate the company's performance. Profitability indicators are most
useful when compared to companies making the same kind of business, company history,
or the average indicator for a company's industry.

Gross Profit Ratio

The gross profit ratio is a type of profitability ratio that evaluates a business's ability to
generate profits before considering the selling and administrative expenses. Moreover, it
measures the ability of the business to sell products in a cost-effective method.

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Unit 5: Interpreting and Analyzing Financial Statements

The formulas involved in calculating the gross profit ratio are the following:

Where Net Sales equal to:

Closer Look

Calculating and Interpreting the Gross Profit Ratio

Your income statement shows the following accounts and their respective
values: Sales for the month amounted to ₱55,000. There were various
returns made by customers due to some orders with factory defects,
amounting to ₱5,000, and the cost of goods sold amounted to ₱27,650.

First, you have to calculate the value of the net sales as follows:

No sales discounts are given, so only the sales returns and allowances are
deducted from sales to get the net sales. Then, you simply substitute the
values and solve for the gross profit ratio. The gross profit ratio is typically
displayed as a percentage as it is more convenient to present it this way,
especially for analytical purposes.

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You can conclude that your gross profit is 0.447 or 44.70% of net sales.

Net Profit Ratio

A net profit ratio, also known as a net profit margin ratio, calculates the profit percentage
in relation to the total revenue. It measures the net profit that the company obtains on a
per-peso-of-revenue-gained basis. For example, a 24% net profit ratio means that for each
₱1 of revenue, the company earns ₱0.24 in net profit.

The net profit margin is equal to net profit (net income) divided by total revenue, expressed
as a percentage.

Net profit is calculated by deducting total company expenses from its total revenue.

Closer Look

Calculating and Interpreting the Net Profit Ratio

For example, your business recorded net profit and net sales amounting
to ₱29,976 and ₱124,900, respectively. Apply the following formula to
arrive at the net profit ratio:

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Your business's net profit ratio is 24% of total income for the period.

Efficiency Ratios
The activity ratio is a measure that indicates how efficiently a company uses its balance
sheet assets to generate revenue and cash. Activity ratio measurements, more commonly
referred to as efficiency ratios, help analysts evaluate how a company handles inventory
management in the business. This measure is key to operational liquidity and overall
financial position.

Activity ratios are most useful when comparing two competing companies in the same
industry. The ratio is useful in determining if a particular company is performing well
relative to its peers. You can use these numbers to give a future outlook for the company's
expected performance.

Accounts Receivable Turnover

Accounts receivable turnover is the number of times a company collects its average
accounts receivable on a yearly basis. Accountants and analysts alike use accounts
receivable turnover to measure how efficiently a company recovers the credit it offers to its
customers (Dauderis and Annand 2017).

It can be described as the ratio of net credit sales and the average accounts receivable. The
mathematical formula is:

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To calculate average accounts receivable, add the beginning and ending balances of
accounts receivable and divide the total by 2. You are calculating the average accounts
receivable for a given period, so you have to divide it by 2 to get its average value. Take that
number and divide it into the period's net credit sales to get the accounts receivable
turnover.

This ratio gives the company a good idea of how efficiently it is recovering the debt owed by
credit customers to the company. The smaller the resulting number, the higher the
efficiency of collection.

Closer Look

Calculating and Interpreting the Accounts Receivable Turnover

Your company reported net sales of ₱45,000, of which 64% were from
credit customers. Furthermore, your beginning accounts receivable
amounted to ₱7,400, and your ending accounts receivable amounted to
₱8,570.

Follow the steps below to calculate the accounts receivable turnover:

First, calculate the average account receivable.

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The final step is to substitute the values and use the formula to calculate
the accounts receivable turnover.

From this, you can conclude that the company collected its accounts
receivables 3.61 times per year. You can further analyze this by
calculating the average number of days it takes on average to collect the
receivables from when the customers took up the credit to when they
paid it. To do this, divide the total number of days a year by the accounts
receivable turnover. 365 divided by 3.61 will give you approximately 101
days or over three months.

Inventory Turnover
Inventory turnover indicates the number of times a company sells and replenishes
inventory over a specific time. You can also use this formula to calculate the days it will take
to sell an existing inventory. The following are the formulas for generating the inventory
turnover ratio:

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Unit 5: Interpreting and Analyzing Financial Statements

Where Average Inventory is:

A higher inventory turnover is preferable to a lower one, as high turnover indicates strong
sales. Effective inventory management depends on knowledge of inventory turnover.

You should note that one cannot use these numbers alone to conclude if the business's
inventory turnover is good or bad. The analyst must consider the industry the business is
engaged in. For instance, an enterprise engaged in selling perishable and fast-moving
inventories should have a higher inventory turnover standard than a business involved in
selling high-end luxury items, such as jewelry, which tend to have a lower inventory
turnover.

Closer Look

Calculating and Interpreting the Inventory Turnover

Assume that in 2021 you have beginning and ending inventories of
₱150,000 and ₱90,000, respectively, and a cost of goods sold amounting
to ₱1,200,000.

First, you have to compute the average inventory for the year as follows:

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With this, you can continue and substitute the values to get the inventory
turnover for the year.

It means that inventory was sold and restocked ten times for the year.
Another way to state this is the business sold that inventory within
approximately 36.50 days or 1.22 months. This result is derived by
dividing 365 days by the inventory turnover.

Check Your Progress

Are the figures resulting from financial ratio calculations absolute metrics in
business? Explain your answer.
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

Solvency Ratios
Solvency ratios are metrics used to measure a company's ability to meet its long-term
financial obligations. These ratios indicate if the company's cash flow is sufficient to meet its
long-term liabilities and thus, serve as a measure of its financial health. An unfavorable ratio
can indicate some likelihood that a company will not be able to pay its long-term debt.

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Solvency ratios are one of many metrics used to determine whether a company can stay
solvent in the long term. It assesses a company's ability to stay afloat in the long run.

Debt-to-Equity Ratio
The debt-to-equity ratio is used to assess a company's financial leverage and is calculated
by dividing the total company debt by the total equity of the company. It measures how
much a company funds its business through liabilities. Moreover, it can also be interpreted
as a reflection of the equity's ability to cover all outstanding debt. The information needed
for this type of ratio is presented on the balance sheet.

The formula for calculating the debt-to-equity ratio is as follows:

The following table shows how you can interpret debt-to-equity ratio figures.

Table 3. Levels of Debt-to-equity ratio

Values Interpretation

Lower than 1 Relatively safe.

1 to 1.9 Probably safe, depending on further analysis.

2 or Greater Considered to be very risky in terms of investment.

Similar to other inventory turnovers, one should analyze the nature of the business and the
industry to evaluate the debt-to-equity level and determine whether it is good or bad.

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Unit 5: Interpreting and Analyzing Financial Statements

Closer Look

Calculating and Interpreting the Debt-to-Equity Ratio

Assume that your company's balance sheet shows total liabilities
amounting to ₱1,257,000 and total shareholders' equity amounting to
₱2,205,263. To calculate the debt-to-equity ratio, you simply substitute
the values and proceed with your calculations.

The company's funding is 57% from debt and 43% from equity. The result
of the debt-to-equity ratio was just converted as a percentage, and the
difference when subtracting 57% from 100% is the funding from equity
sources.

Applying Financial Ratios in Business

Financial ratios are a way to gauge the business's performance and identify potential
problems. These ratios tell information about a company's earning capacity, solvency,
efficiency, and debt levels.

The primary duty of an analyst is to perform a thorough analysis of financial statements.

These ratios are the results of dividing an account balance or other financial measure with
another account balance or other financial measure. Typically, these measures or account
balances are found on the company's financial statements—the balance sheet or income
statement.

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Unit 5: Interpreting and Analyzing Financial Statements

Financial ratios provide business owners and managers with a means to measure a
company's performance in terms of predefined goals and compare it with competitors and
industry norms. Moreover, it is most effectively used when comparing results over multiple
periods. It allows companies to track their business performance over time and spot signs
of problems. Ratios are also used by bankers, investors, and business analysts to gauge a
company's financial health.

Check Your Progress

Is it beneficial to evaluate company performance using financial ratios?

Explain.
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

Case Study

The Surging Profits of Tesla Along With its Increase in Prices

Tesla's gross profits and profits soar to record highs as prices rise. This
occurrence is attributed to the rising costs of automakers. Price increases
have become one of the biggest stories in the automotive industry and
many other industries in recent years.

Tesla is no exception, with vehicle prices increasing by nearly 12% in the

last two years. Automakers have repeatedly justified rising prices as
inflation-related, and due to raw material, and logistics costs.

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However, there was a concern that Tesla would raise prices as it could be
supported by the steadily increasing gross car profits over the same
period due to a strong backlog of electric cars since Tesla reported a
record 32.9% gross margin for cars last quarter.

It surely affects Tesla's gross profit ratio. If all else were constant, the
increase in gross profits would also result in an increase in gross profit
ratio for the year.

Tesla’s gross margin and profits are surging along with

prices, and it had to explain itself
Lambert, Fred. “Tesla's Gross Margin and Profits Are Surging
along with Prices, and It Had to Explain Itself.” Electrek, April
22, 2022.
https://electrek.co/2022/04/22/tesla-gross-margin-profits-sur
ging-along-with-prices-explained/.

Keep in Mind

● Financial ratios are generated from the financial data reported in financial
statements. Drawing a more comprehensive understanding of the company's overall
condition and performance is called ratio analysis.
● As shown in the figure below, financial ratios can be categorized into major groups.

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● The descriptions of each financial ratio are summarized in the table below.

Ratio Description

Current Ratio measures a company's ability to pay short-term

obligations by calculating the ratio of current assets to
current liabilities

Working Capital the amount derived when current liabilities are deducted
from current assets

Gross Profit Ratio evaluates the ability of a business to generate profits

before considering the selling and administrative
expenses

Net Profit Ratio measures the net profit that the company obtains on a
per-peso-of-revenue-gained by calculating the percentage
of profit in relation to total revenue

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Ratio Description

Accounts Receivable the number of times a company collects its average

Turnover Ratio accounts receivable on a yearly basis; the ratio between
net credit sales and average accounts receivables

Inventory Turnover the number of times a company sells and replenishes

Ratio inventory over a specific time period; the number of days
it takes to sell an existing inventory

Debt-to-equity Ratio assess a company's financial leverage; calculated by

dividing the total company debt by the total equity

Try This
A. True or False. Write true if the statement is correct. Otherwise, write false.

________________ 1. Financial ratios are created using financial statement figures to

provide meaningful information about the company.

________________ 2. Ratio analysis is a quantitative way to gain insights into various

parameters that the company may use to measure different
performance levels.

________________ 3. Only investors use liquidity ratios to gauge how well a business is
performing.

________________ 4. The current ratio is also known as the company's balance sheet
ratio.

________________ 5. Financial ratios provide business owners and managers with a

means to measure a company's performance in terms of
predefined goals and compare it with competitors and industry
norms.

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B. Matching Type. Match the words in column A with the definitions in column B.

Column A Column B

________ 1. Gross Profit a. It is the resulting figure after deducting

Ratio current liabilities from current assets.

________ 2. Current Ratio b. It evaluates the ability of a business to

generate profits before considering the
selling and administrative expenses.

________ 3. Working c. It is calculated by dividing the total

Capital company debt by the total equity

________ 4. Inventory d. It is also known as the working capital ratio.

Turnover

________ 5. Debt-to-Equity e. It is the number of days it takes to sell an

Ratio existing inventory.

Practice Your Skills

Calculating Financial Ratios

Company ABC wants to calculate its liquidity, solvency, and activity ratios using its 3-year
balance sheet. Help them by performing the required calculations.

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Company ABC
Comparative Balance Sheet

2019 2020 2021

Assets
Current Assets
Cash ₱2,367,380 ₱5,425,907 ₱5,427,632

Trade and other receivables - net 1,600,681 1,573,825 1,446,825

Merchandise Inventory - net 115,954 139,055 206,393

Prepayments and other current assets 0 74,070 0

Total current assets ₱4,084,015 ₱7,212,857 ₱7,080,850

Non-Current Assets
Property and equipment - net 247,582 418,509 213,998

Investment in equity securities 74,156 448,728 219,999

Other assets 286,508 1,133 1,280

Total non-current assets ₱608,246 ₱868,370 ₱435,277

Total Assets ₱4,692,261 ₱8,081,227 ₱7,516,127

Liabilities and Shareholders’ Equity

Current Liabilities
Trade and other payables 2,656,086 2,837,159 3,570,994

Total current liabilities 2,656,086 2,837,159 3,570,994

Long-Term Liabilities
Long-term debt payable 234,667 0 0

Total long-term liabilities 234,667 0 0

Shareholders’ Equity

Share Capital - Issued and outstanding 1,801,508 5,244,068 3,945,133

Total shareholders’ equity 1,801,508 5,244,068 3,945,133

Total Liabilities and Shareholders’ Equity ₱4,692,261 ₱8,081,227 ₱7,516,127

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Unit 5: Interpreting and Analyzing Financial Statements

1. What is the current ratio for 2020?

2. What is the working capital for the year 2019?

3. What is the inventory turnover ratio for 2021 assuming the Cost of Goods Sold is
7,047,139?

4. Calculate the Debt-to-Equity ratio for all three years.

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5. Suppose the Net Sales for 2020 are ₱4,531,000 and the Cost of Goods Sold is
₱1,294,188. Calculate the Gross Profit Ratio.

Challenge Yourself

Answer the following questions.

1. The following are the account balances for XYZ Company on December 31, 2018:
Total Assets: ₱435,500
Non-current portion of assets: ₱347,200
Current liabilities: ₱223,650

What is XYZ company’s current ratio for the year 2018? Interpret the result.

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2. The following are the account balances for ABC Company on December 31, 2019:
Total Assets: ₱745,580
Total Liabilities: ₱207,740
For December 31, 2020, the following data were taken from the balance sheet:
Total Assets: ₱927,940
Total Liabilities: ₱299,600

What is the difference between the 2020 and 2019 debt-to-equity ratios?

3. The following are the account balances for ABC Company on December 31, 2019:
Total Assets: ₱575,520
Non-current assets: ₱327,730
Total liabilities: ₱817,520
Non-current portion of total liabilities: ₱578,840

What is the working capital for the year 2019? Explain the implications of the result.

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Bibliography

Dauderis, Henry, and Annand David. Introduction to Financial Accounting (Version

2017-Revision C). Athabasca, Canada: Valley Educational Services Ltd., 2017.

Gilbertson, Claudia, Mark Lehman, and Debra Gentene. Century 21 Accounting. Ohio:
South-Western Cengage Learning, 2016.

Jonick, Christine. Principles of Financial Accounting. Dahlonega, Georgia: University of North

Georgia Press, 2018.

Hermanson, Roger H., James Don Edwards, and R. F. Salmonson. Accounting Principles.
Homewood, IL: BPI-Irwin, 1989.

Lambert, Fred. “Tesla's Gross Margin and Profits Are Surging along with Prices, and It Had to
Explain Itself.” Electrek, April 22, 2022.
https://electrek.co/2022/04/22/tesla-gross-margin-profits-surging-along-with-prices-e
xplained/.

5.3. Financial Ratios 29