ANALYSIS OF FINANCIAL

STATEMENTS
Topic Objectives:
At the end of this topic, you should be able to:
• Explain what ratio analysis is.
• List the five groups of ratios and identify,
calculate, and interpret the key ratios in each
group.
• Discuss each ratio’s relationship to the balance
sheet and income statement.
• Calculate the financial ratios of the projected
financial statements of each group’s business
plan.
RATIO ANALYSIS
 5 Categories of Financial Ratios
1. Liquidity ratios – it gives us an idea of the firm’s
ability to pay off debts that are maturing within a
year. These are ratios that show the relationship of a
firm’s cash and other current assets to its current
liabilities.
2. Asset management ratios – gives us an idea on how
efficiently the firm is using its assets. A set of ratios
that measure how effectively a firm is managing its
assets.
3. Debt management ratios – gives us an idea of how the
firm has financed its assets as well the firm’s ability to
repay its long-term debt. A set of ratios that measure
how effectively a firm manages its debt.
 5 Categories of Financial Ratios
4. Profitability ratios – gives us an idea of how profitably
the firm is operating and utilizing its assets. These are
group of ratios that shoe the combined effects of
liquidity, asset management, and debt on operating
results.
5. Market value ratios – brings us in the stock price and
give us an idea of what investors think about the firm
and its future prospects. These are ratios that relate
the firm’s stock price to its earnings and book value
per share.
LIQUIDITY RATIOS
A. Current ratio – this ratio is calculated by
dividing current assets by current liabilities. It
indicates the extent to which current liabilities
are covered by those assets expected to be
converted to cash in the near future.

B. Quick (acid test) ratio – this ratio is calculated

by deducting inventories from current assets
and then dividing the remainder by current
liabilities.
ASSET MANAGEMENT RATIOS
1. Inventory turnover ratio – this ratio is
calculated by dividing sales by inventories,
2. Days Sales Outstanding (DSO) – this ratio is
calculated by dividing accounts receivable by
average sales per day; it indicates the average
length of time the firm must wait after making
a sale before it receives cash.
3. Fixed Assets Turnover ratio – the ratio of sales
to net fixed assets.
4. Total Asset Turnover ratio – this ratio is
calculated by dividing sales by total assets.
DEBT MANAGEMENT RATIOS
1. Total Debt to Total Assets (Debt ratio) - the
ratio of total debt to total assets.
2. Times-Interest Earned (TIE) ratio – the ratio of
earnings before interest and taxes (EBIT) to
interest charges; a measure of the firm’s ability
to meet its annual interest payments.
PROFITABILITY RATIOS
1. Operating Margin – this ratio measures
operating income, or EBIT, per dollar (peso) of
sales; it is calculated by dividing operating
income by sales.
2. Profit margin – this ratio measures net income
per dollar (peso) of sales and is calculated by
dividing net income by sales.
3. Return on Total Assets (ROA) – the ratio of the
net income to total assets.
PROFITABILITY RATIOS
4. Basic Earning Power (BEP) ratio – this ratio
indicates the ability of the firm’s assets to
generate operating income; it is calculated by
dividing EBIT by total assets.
5. Return on Common Equity (ROE) – the ratio of
net income to common
Financial Statements for Ratio Analysis
SAXTON COMPANY
Income Statement
For the Year Ended December 31,2016

Sales (all on credit) P 4,000,000

Cost of Goods Sold 3,000,000
Gross Profit P 1,000,000
Selling and Administrative expense 450,000
Operating Profit 550,000
Interest Expense 50,000
Extraordinary Loss 200,000
Net Income Before Taxes P 300,000
Taxes (33%) 100,000
Net Income P 200,000
 Balance Sheet
As of December 31,2016
Assets
Cash P 30,000
Marketable Securities 50,000
Accounts Receivable 350,000
Inventory 370,000
Total Current Assets P 800,000
Net Plant and Equipment 800,000
Total Assets P1,600,000
Liabilities and Stockholder’s Equity
Accounts Payable P 50,000
Notes Payable 250,000
Total Current Liabilities P 300,000
Long-term Liabilities 300,000
Total Liabilities P 600,000
Common Stock 400,000
Retained Earnings 600,000
Total Liabilities and SHE P1,600.000
USES OF RATIOS
• Ratio analysis is used by three main groups:
1. Managers – who use ratios to help analyze,
control, and thus, improve their firm’s
operations.
2 . Credit analysts – (including bank loan
officers and bond rating analysts) who analyze
ratios to help judge a company’s ability to repay
its debts.
3. Stock analysts – who are interested in a
company’s efficiency, risk, and growth prospects
LIMITATIONS OF RATIOS
1. It is difficult to develop a meaningful set of
industry averages for firms having divisions
that operate in different industries.
2. Most firms want to be better than average, so
merely attaining average performance is not
necessarily good.
3. Inflation has distorted many firms’ balance
sheets – book values are often different from
market values.
4. Seasonal factors can also distort a ratio
analysis.
LIMITATIONS OF RATIOS
5. Firms can employ “window dressing” techniques
to improve their financial statements..
- Window dressing techniques – are techniques employed by
firms to make their financial statements look better than they really
are.
6. Different accounting practices can distort
comparisons.
7. It is difficult to generalize about whether a particular
ratio is “good” or “bad”.
8. Firms often have some ratios that look “good” and
others that look “bad”, making it difficult to tell
whether the company is, on balance, strong or weak.
Let’s solve some problems:
1. Maruwa Co. has a DSO of 35 days, and its
annual sales are P6,800,000. what is its
accounts receiveble balance? Assume that it
uses a 365-day year.
2. The inventory turnover rate of Li Ning’s Co is
7.37 in 2011. if the industry average is 5.24, we
say that
a.. Li Ning’s has better inventory management
than industry average.
b. Li Ning’s inventory level is low.
Which statement is correct?
Let’s solve some problems:
3. The following is part of Want China’s financial
data:
long-term liabilities - P2,000,000
stockholders’ equity - 1,500,000
fixed assets and other assets- 3,600,000
inventory - 700,000
Current assets - 1,600,000

What is the current ratio and quick ratio of Want

China?
Let’s solve some problems:
4. A firm has current assets of P3,000,000 with a
current ratio of 1.2. its quick ratio is 0.8.. What
is its (a) current liabilities, and (b) inventory?
5. Datang Power currently has P750,000 in
accounts receivable, and its days sales
outstanding (DSO) is 55 days. It wants to
reduce its Dso to 35 days by pressuring more of
its customers to pay their bills on time.. If this
policy is adopted, the company’s average sales
will fall by 15%. What will be the level of
accounts receivable following the cahnge?
Assume a 365-day year..