Financial Ratios

1. MEASUREMENT LEVELS

One of the qualitative characteristics of a good financial statement is comparability. It allows the identification of similarities and differences between the statements being compared. The following are the different financial ratios used in comparing financial statements:

a. LIQUIDITY RATIOS

Liquidity is the capacity of a company to pay its currently maturing obligations. A good liquidity position encourages banks or financial institutions to lend, while a bad liquidity position may scare off potential creditors.

Example:

Alpha Company has a maturing loan next month amounting to P255,000. Upon review of its financial statement, they discovered that Cash and Accounts Receivable have balances that can pay off the loan. Therefore, creditors can conclude that Alpha Company has a good liquidity standing.

Liquidity Ratios

a. Working Capital

Working capital is the difference between current assets and current liabilities.

FORMULA:
Working Capital = Current Assets - Current Liabilities

A positive working capital is preferred because it indicates that there are enough current assets to pay all current liabilities. A negative working capital must be avoided as it means current liabilities exceed current assets.

Example:

Given the data of Alpha Company:

Year	Current Assets	Current Liabilities	Working Capital
2017	P200,000	P250,000	P-50,000
2018	P305,000	P410,000	P-105,000

For both years, the company has positive working capital which is a good sign.

b. Current Ratio

The current ratio is the quotient of current assets divided by current liabilities.

FORMULA:
Current Ratio = Current Assets / Current Liabilities

Example:

Year	Current Assets	Current Liabilities	Current Ratio
2017	P250,000	P100,000	2.5
2018	P410,000	P155,000	2.6

c. Acid Test Ratio

The acid test ratio compares the total of a company's cash, marketable securities, and accounts receivable to the total amount of the current liabilities.

FORMULA:
Acid Test Ratio = Quick Assets / Current Liabilities

Example:

Year	Quick Assets	Current Liabilities	Acid Test Ratio
2017	P463,000	P260,000	1.78
2018	P455,000	P250,000	1.82

d. Accounts Receivable Turnover Ratio

This ratio measures the frequency of conversion of the company's Accounts Receivable to Cash.

FORMULA:
Accounts Receivable Turnover Ratio = Total Net Credit Sales / Average Accounts Receivable

Example:

Year	Net Credit Sales	Average Accounts Receivable	Turnover Ratio
2017	P780,000	P71,000	10.99
2018	P1,050,000	P79,000	13.29

e. Average Collection Period

The average collection period is the average number of days that it takes to collect receivables.

FORMULA:
Average Collection Period = 365 / Accounts Receivable Turnover Ratio

Example:

Year	Average Collection Period
2017	33.21 days
2018	27.46 days

f. Inventory Turnover Ratio

This ratio indicates how efficiently a company sells its entire inventory.

FORMULA:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Example:

Year	Inventory Turnover Ratio
2017	6.53 times
2018	8.25 times

g. Average Days in Inventory

This ratio computes the average time a company takes to sell its inventory.

FORMULA:
Average Days in Inventory = 365 / Inventory Turnover Ratio

Example:

Year	Average Days in Inventory
2017	55.90 days
2018	44.24 days

h. Number of Days in Operating Cycle

The operating cycle measures how long it takes to convert inventory back to cash.

FORMULA:
Number of Days in Operating Cycle = Collection Period + Average Days in Inventory

Example:

Year	Days in Operating Cycle
2017	122.38 days
2018	99.20 days

2. SOLVENCY RATIOS

Solvency refers to a company's ability to meet its long-term debts and financial obligations.

a. Debt to Total Assets Ratio

FORMULA:
Debt to Total Assets Ratio = Total Liabilities / Total Assets

Example:

Year	Total Liabilities	Total Assets	Debt to Total Assets Ratio
2017	P950,000	P1,450,000	0.65
2018	P1,050,000	P1,850,000	0.56

b. Debt to Equity Ratio

This ratio indicates the relative proportion of shareholder's equity and debt

FORMULA:
Debt to Equity Ratio = Total Liabilities / Total Shareholder's Equity

Example:

Year	Total Liabilities	Total Shareholder's Equity	Debt to Equity Ratio
2017	1,250,000	455,000	2.75
2018	1,600,000	520,000	3.07

c. Times Interest Earned Ratio

This ratio indicates how easily a company can pay interest on outstanding debt.

FORMULA:
Times Interest Earned Ratio = EBIT / Interest Expense

Example:

Year	EBIT	Interest Expense	Times Interest Earned Ratio
2017	P3,100,000	P450,000	6.88
2018	P2,650,000	P450,000	5.89

3. PROFITABILITY RATIOS

These ratios assess a company's ability to generate profit.

a. Gross Profit Ratio

Gross profit is the difference between revenue and cost of goods sold. The gross profit ratio indicates how efficiently a company produces and sells its goods.

FORMULA:
Gross Profit Ratio = Gross Profit / Net Sales

Example:

Year	Gross Profit	Net Sales	Gross Profit Ratio
2017	P3,950,000	P4,900,000	79.31%
2018	P4,600,000	P5,800,000	80.61%

b. Profit Margin Ratio

The profit margin ratio indicates how much profit a company makes for every unit of currency earned in revenue.

FORMULA:
Profit Margin Ratio = Net Income / Net Sales

Example:

Year	Net Income	Net Sales	Profit Margin Ratio
2017	P795,000	P4,900,000	16.20%
2018	P873,000	P5,800,000	15.06%

c. Operating Expenses to Sales Ratio

This ratio assesses the proportion of operating expenses to net sales.

FORMULA:
Operating Expenses to Sales Ratio = Operating Expenses / Net Sales

Example:

Year	Operating Expenses	Net Sales	Operating Expenses to Sales Ratio
2017	P850,000	P4,900,000	17.35%
2018	P660,000	P5,800,000	11.38%

d. Return on Investment Ratio (ROI)

d.1. Return on Assets (ROA)

The ROA indicates how effectively a company uses its assets to generate profit.

FORMULA:
ROA = Net Income / Average Total Assets

Example:

Year	Net Income	Average Total Assets	ROA
2017	P1,500,500	P1,850,000	0.81
2018	P1,150,000	P2,120,000	0.54

d.2. Return on Equity (ROE)

The ROE measures the ability of a company to generate profits from its shareholders' equity.

FORMULA:
ROE = Net Income / Average Stockholder's Equity

Example:

Year	Net Income	Average Stockholder's Equity	ROE
2017	P1,500,500	P425,000	3.53
2018	P1,150,000	P550,000	2.09

e. Asset Turnover Ratio

This ratio indicates how efficiently a company uses its assets to generate sales.

FORMULA:
Asset Turnover Ratio = Net Sales / Average Total Assets

Example:

Year	Net Sales	Average Total Assets	Asset Turnover Ratio
2017	P4,900,000	P1,850,000	2.65
2018	P5,800,000	P2,120,000	2.73

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Measurement Levels

Measurement levels refer to the qualitative characteristics of financial statements, particularly comparability. This allows for the identification of similarities and differences between the statements being compared.

1. Liquidity Ratios

Definition: Liquidity ratios measure a company's ability to meet its short-term obligations using its most liquid assets.

- Working Capital

Definition: The difference between current assets and current liabilities.

Formula: Working Capital = Current Assets - Current Liabilities

Notes:

• Positive working capital indicates a good liquidity position.
• Negative working capital indicates potential default.

- Current Ratio

Definition: The ratio of current assets to current liabilities.

Formula: Current Ratio = Current Assets / Current Liabilities

- Acid Test Ratio (Quick Ratio)

Definition: Measures a company's ability to meet current liabilities without relying on inventory.

Formula: Acid Test Ratio = Quick Assets / Current Liabilities

- Accounts Receivable Turnover Ratio

Definition: Measures how efficiently a company collects its receivables.

Formula: Accounts Receivable Turnover Ratio = Total Net Credit Sales / Average Accounts Receivable

- Average Collection Period

Definition: The average number of days it takes to collect receivables.

Formula: Average Collection Period = 365 / Accounts Receivable Turnover Ratio

- Inventory Turnover Ratio

Definition: Measures how many times a company's inventory is sold and replaced over a period.

Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

- Average Days in Inventory

Definition: The average number of days it takes to sell inventory.

Formula: Average Days in Inventory = 365 / Inventory Turnover Ratio

- Number of Days in Operating Cycle

Definition: The total time taken for cash to be invested in operations and returned to cash.

Formula: Number of Days in Operating Cycle = Average Collection Period + Average Days in Inventory

2. Solvency Ratios

Definition: Solvency ratios measure a company's ability to meet its long-term debts and financial obligations.

- Debt to Total Assets Ratio

Definition: Proportion of total liabilities to total assets.

Formula: Debt to Total Assets Ratio = Total Liabilities / Total Assets

- Debt to Equity Ratio

Definition: Compares total liabilities to shareholders' equity.

Formula: Debt to Equity Ratio = Total Liabilities / Total Shareholders' Equity

- Times Interest Earned Ratio

Definition: Measures a company's ability to meet interest payments with its earnings.

Formula: Times Interest Earned Ratio = EBIT / Interest Expense

3. Profitability Ratios

Definition: Profitability ratios assess a company's ability to generate income relative to revenue, assets, or equity.

- Gross Profit Ratio

Definition: The proportion of gross profit to net sales.

Formula: Gross Profit Ratio = Gross Profit / Net Sales

- Profit Margin Ratio

Definition: Measures net income as a percentage of net sales.

Formula: Profit Margin Ratio = Net Income after Tax / Net Sales

- Operating Expenses to Sales Ratio

Definition: Compares operating expenses to net sales.

Formula: Operating Expenses to Sales Ratio = Operating Expenses / Net Sales

- Return on Investment Ratio (ROI)

Definition: Measures the profitability of investments in assets or equity.

Return on Assets (ROA)

Formula: Return on Assets = Net Income / Average Total Assets

Return on Equity (ROE)

Formula: Return on Equity = Net Income / Average Stockholder's Equity

- Asset Turnover Ratio

Definition: Measures sales generated for each dollar of assets owned.

Formula: Asset Turnover Ratio = Net Sales / Average Total Assets