The above may be evaluated as follows:

 The cost of goods sold is 29.55% of sales. The company has a gross profit
rate of 70.45%. Operating expenses are 15.91% of sales.
 The company earns income of P 0.33 for every peso of sales.
 Gross profit generated for every peso of sale is P 0.70

Lesson 5.2. Different Financial Ratios

Financial ratios in accounting can be classified into three groups:

1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios

Liquidity Ratios

Liquidity is the capacity of a company to pay its currently maturing obligations.

These would require a good amount of cash and other liquid assets such as
accounts receivable, inventory, trading securities, and prepaid assets.

These ratios are very important to the short term creditors of a company. It will
determine if the borrowing company is in a position to pay the borrowed principal and
interest when they fall due.

To better understand the financial ratios, let us have an illustrative example of

the computation using the sample Financial Statements of GSM Company shown
below:

GSM COMPANY
Comparative Balance Sheet
For the Year 2018 and 2019
ASSETS 2018 2019
Cash 450,000.00 500,000.00
Accounts Receivable 300,000.00 330,000.00
Trading Securities 170,000.00 80,000.00
Inventories 420,000.00 470,000.00
Prepaid Expenses 70,000.00 130,000.00
Total Current Assets 1,410,000.00 1,510,000.00

Total Noncurrent Assets 890,000.00 1,190,000.00

Total Assets 2,300,000.00 2,700,000.00

LIABILITIES
Total Current Liabilities 450,000.00 500,000.00
Total Noncurrent Liabilities 1,150,000.00 1,350,000.00
Total Liabilities 1,600,000.00 1,850,000.00
OWNER’S EQUITY
Total Owner’s Equity 700,000.00 850,000.00
Total Liabilities & owner’s Equity 2,300,000.00 2,700,000.00

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 GSM COMPANY
Comparative Income Statement
For the Year 2018 and 2019
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Less: Cost of Goods Sold 1,000,000.00 1,300,000.00
Gross Profit 4,000,000.00 4,500,000.00
Less: Operating Expenses 800,000.00 300,000.00
Earnings Before Interest and Taxes 3,200,000.00 4,200,000.00
Less: Interest Expense 300,000.00 1,800,000.00
Net Income before Tax 2,900,000.00 2,400,000.00
Less: Income Tax Expense 550,000.00 400,000.00
Net Income after Tax 2,350,000.00 2,000,000.00

Different ratios under liquidity ratio are shown below:

1. Working Capital
Liquidity capital is the difference between current assets and current
liabilities. This is one of the simplest liquidity ratios. A positive working
capital is preferred because it would mean that there are enough
current assets to pay all of the current liabilities at the moment.
Formula: Working Capital = Current Assets – Current Liabilities
Using the GSM Company data, we would be able to compute the company’s
working capital for 2018 and 2019.
2018 2019
Current Assets 1,410,000.00 1,510,000.00
Less: Current Liabilities 450,000.00 500,000.00
Working Capital 960,000.00 1,010,000.00

Analysis: For both periods, the company has a positive working capital. This is
something good. However, comparing the two periods, we can conclude that
GSM Company is in a better liquidity position in the year 2019 than in 2018.

2. Current Ratio
Current ratio is the quotient of current assets divided by the current
liabilities of the company. As much as possible, a whole number
current ratio is preferred.
Formula: Current Ratio = Current Assets / Current Liabilities
Using the GSM Company data, we would be able to compute the company’s
current ratio for 2018 and 2019.
2018 2019
Current Assets 1,410,000.00 1,510,000.00
Divided by: Current Liabilities 450,000.00 500,000.00
Current Ratio 3.13 3.02

Analysis: GSM Company has P 3.13 worth of current assets for every P 1.00
of current liabilities for the year 2018. This is something positive. However,

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 comparing the two periods, the company has a slightly better current ratio in
2018 than in 2019.

3. Acid Test Ratio

Acid Test Ratio is a more strict variation of the current ratio formula. It
removes Inventory and Prepaid Expenses from the numerator
component. Only Cash, Receivables, and Trading Securities also
known as Quick Assets will be left.
Formula: Acid Test Ratio = Quick Assets / Current Liabilities
Using the GSM Company data, we would be able to compute the company’s
acid test ratio for 2018 and 2019.
2018 2019
Quick Assets 920,000.00 910,000.00
Divided by: Current Liabilities 450,000.00 500,000.00
Acid Test Ratio 2.04 1.82

Analysis: GSM Company has P 2.04 worth of quick assets for every P 1.00 of
current liabilities for the year 2018. This is something positive. It means that it
really has the capability to pay its maturing obligations through its quick
assets. Comparing both years, however, would reveal that the company was
better off in 2018 than in 2019.

4. Accounts Receivable Turnover Ratio

This ratio measures the frequency of conversion of the company’s
Accounts Receivable to Cash. It measures how many times the
company collected its Accounts Receivable from its customers.
Formula: Accounts Receivable Turnover Ratio = Net Sales / Accounts
Receivable
Using the GSM Company data, we would be able to compute the company’s
accounts receivable turnover ratio for 2018 and 2019.
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Divided by: Accounts 300,000.00 330,000.00
Receivable
Accounts Receivable 16.66 times 17.57 times
Turnover Ratio

Analysis: Comparing the compound Accounts Receivable Turnover

Ratios for the two years, it can be seen that the company has a higher ratio
for 2019. This can be attributed to a better performance from its collection
department.

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5. Average Collection Period
The average collection period states the usual number of days it would
take before the company would be able to collect a certain group of
receivables. The Accounts Receivable Turnover itself is a component
for the computation of the average collection period. It serves as the
denominator in the formula. For the numerator, the company makes
use of either 360 or 365 days depending on the policy of the company.
Formula: Average Collection Period = 365 days / A/R Turnover Ratio
Using the GSM Company data, we would be able to compute the company’s
average collection period for 2018 and 2019.
2018 2019
No. of days 365 365
Divided by: Accounts 16.66 17.57
Receivable Turnover Ratio
Average Collection Period 21.91 days 20.77 days

Analysis: The shorter average collection period in 2019 shows that the
collection department increased its efforts to collect company receivables as
they fall due. It can be seen in our computation that the company has a better
Accounts Receivables Turnover Ratio and Average Collection Period in 2019
than in 2018. A shorter average collection period means that the company
has more immediate cash that can be used in its operation.

6. Inventory Turnover Ratio

This ratio measures the number of times the company was able to sell
its entire inventory to customers during the year. As much as possible,
the goal is to have a high inventory ratio. A high turnover ratio shows
how efficient the company is in selling its inventory to customers.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Inventory
Using the GSM Company data, we would be able to compute the company’s
inventory turnover ratio for 2018 and 2019.
2018 2019
Cost of Goods Sold 1,000,000.00 1,300,000.00
Divided by: Inventory 420,000.00 470,000.00
Inventory Turnover Ratio 2.38 times 2.76 times

Analysis: It can be seen in our computation that the inventory slightly

increased in 2019. It means that the sales department sold more products to
customers in 2019.

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7. Average Days in Inventory
This ratio states the number of days that it would take before an
inventory would be entirely sold by the company. This follows the same
concept in computing the average collection period. The goal is to have
shorter average days in inventory. A shorter amount would mean that
the cash of the company is not being tied to its inventory for a very long
period of time.
Formula: Average Days in Inventory = No. of days / Inventory Turnover Ratio
Using the GSM Company data, we would be able to compute the company’s
average days in inventory for 2018 and 2019.
2018 2019
No. of days 365 365
Divided by: Inventory 2.38 2.76
Turnover Ratio
Average Days in Inventory 153.36 days 132.25 days

Analysis: This means that the company will take 153 days to sell its
entire inventory for the year 2018 while it would only take 132 days for the
year 2019. The average days in inventory of this company improved in 2019.
This is because the inventory turnover in 2019 also improved.

8. Number of Days in Operating Cycle

These are the measures on how long it would take for the company to
transform its inventory back to cash. This is the combination of the
average collection period and the average age of inventory. The goal is
to always have a shorter number of days of operating cycle.
Formula: No. of Days in Operating Cycle = Average Collection Period +
Average Days in Inventory
Using the GSM Company data, we would be able to compute the company’s
no. of days in the operating cycle for 2018 and 2019.
2018 2019
Collecting Period 21.91 20.77
Add: Days in Inventory 153.36 132.25
No. of days in Operating 175.27 days 153.02 days
Cycle

Analysis: A comparison between the two periods shows an

improvement of at least 22 days in the operating cycle. It means that the
company improved as a whole when it comes to selling their products and
collecting their receivables.

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Solvency Ratios
Solvency ratios measure the capability of an entity to pay long term
obligations as they fall due. Creditors of the company’s long term payable and bond
payable will be interested in knowing its solvency ratios.

1. Debt to Total Assets Ratio

This is the proportion between the total liabilities of the company and
its total assets. The debt ratio shows how much of the assets of the
company were given by creditors. As much as possible, current and
prospective creditors want a very low debt to total assets ratio.
Formula: Debt to Total Assets Ratio = Total Liabilities / Total Assets
Using the GSM Company data, we would be able to compute the company’s
debt to total assets ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Debt to Total Assets Ratio .69 .68

Analysis: Comparing the data for the two years involved, it can be seen
that there is a minimal change in the debt ratio of the company. This means
that in 2018, out of the total assets of the company, 69% was being financed
by creditors. A high debt to asset ratio implies a high level of debt.

2. Debt to Equity Ratio

Instead of assets, the debt to equity ratio compares the liabilities of the
company with its equity. A smaller debt to equity ratio would indicate a
healthier solvency position for the company.
Formula: Debt to Equity Ratio = Total Liabilities / Total Owner’s Equity
Using the GSM Company data, we would be able to compute the company’s
debt to equity ratio for 2018 and 2019.
2018 2019
Total Liabilities 1,600,000.00 1,850,000.00
Divided by: Total Owner’s 700,000.00 850,000.00
Equity
Debt to Equity Ratio 2.28 2.17

Analysis: Comparing the debt to equity ratio of the company for two
periods concerned showed that the company was more solvent in 2019 than
in 2018. A high ratio suggests a high level of debt that may result in high
interest expense.

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 3. Times Interest Earned Ratio
The Time Interest Earned Ratio shows the proportion between the
EBIT of the company and its interest expense. It is an indicator of how
many times the company’s EBIT can cover the finance cost of
borrowing. Companies want a high Times Interest Earned Ratio. A
small or decimal number ratio indicates that it is not advisable for a
company to borrow money – especially if the company would not be
able to generate enough income to cover it.
Formula: Times Interest Earned Ratio = EBIT / Interest Expense
Using the GSM Company data, we would be able to compute the company’s
times interest earned ratio for 2018 and 2019.
2018 2019
Earnings Before Income Tax 3,200,000.00 4,200,000.00
Divided by: Interest Expense 300,000.00 1,800,000.00
Times Interest Earned Ratio 10.66 2.33

Analysis: Comparing the times interest earned ratio of the company for
two periods, it can be seen that the company is very solvent in the year 2018
compared to that in 2019. It is 10 times more solvent to pay the interest with
its income before tax.

Profitability Ratios
Profitability ratios measure the ability of the company to generate income from
the use of its assets and invested capital as well as control its cost. The following are
the commonly used profitability ratios:
1. Gross Profit Ratio
This is the proportion of the gross profit of the company with its net
sales. Gross profit is the difference between the net sales of the
company and its cost of goods sold. A company should aim for a
bigger gross profit ratio. A large gross profit ratio shows that a
company can generate more sales from the smaller cost of goods sold
that it has.
Formula: Gross Profit Ratio = Gross Profit / Net Sales
Using the GSM Company data, we would be able to compute the company’s
gross profit ratio for 2018 and 2019.
2018 2019
Gross Profit 4,000,000.00 4,500,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Profit Ratio 80% 77.59%

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 Analysis: This means that for every P 1.00 the company sells, P .80
goes to the gross profit in the year 2018. The company’s gross profit ratio
slightly decreased in 2019. This should be avoided or at least be minimized.
The gross profit ratio can be improved by continuously finding inventories with
lower cost, without sacrificing quality.
2. Profit Margin Ratio
The profit mentioned here is the Net Income After Tax (NIAT). This
ratio measures the proportion between the NIAT and the Net Sales of
the company. This is a more precise measurement of the company’s
profitability because it has already considered the operating expenses
and other expenses of the entity. Companies want a high profit margin
ratio.
Formula: Gross Margin Ratio = Net Income after Tax / Net Sales
Using the GSM Company data, we would be able to compute the company’s
gross margin ratio for 2018 and 2019.
2018 2019
Net Income after Tax 2,350,000.00 2,000,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
Gross Margin Ratio 47% 34.48%

Analysis: This means that company earned P .47 for every P 1.00 of
sales in the year 2018. The company’s gross margin ratio shows a decline for
the year 2019. This can be attributed to the lower NIAT coupled by an
increase in Net Sales.

3. Operating Expenses to Sale Ratio

Operating expenses are the biggest expenses of every company. It can
be further classified into General and Administrative Expenses and
Selling Expenses. These expenses are needed to generate sales. This
ratio should be minimized as much as possible. The goal is to generate
as much sales with the minimum operating expenses.
Formula: Operating Expenses to Sale Ratio = Operating Expenses / Net
Sales
Using the GSM Company data, we would be able to compute the company’s
operating expenses to sale ratio for 2018 and 2019.
2018 2019
Operating Expenses 800,000.00 300,000.00
Divided by: Net Sales 5,000,000.00 5,800,000.00
OE to Sale Ratio 16% 5.17%

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 Analysis: Comparing the data for the two years involved shows that
there is a huge improvement in the operating expenses to sales ratio. This
can be attributed to lower operating expenses and increase in net sales.

4. Return on Assets
Before profits can be realized, certain investments should be made. In
this case, assets will be used for the different projects of the company.
The goal is to generate profit based on the available assets during the
year. Thus, the company aims for a higher return on assets.
Formula: Return on Assets = NIAT / Total Assets
Using the GSM Company data, we would be able to compute the company’s
return on assets for 2018 and 2019.
2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Return on Assets 1.02 0.74

Analysis: Comparing the data for the two years involved shows that in
the year 2018 the return on assets is very high compared to the year 2019.
This can be attributed to a much higher income compared to the assets of the
company.

5. Return on Equity
This is a slight variation of the earlier formula. In this case, it is the
average owner’s/stockholder’s equity that will be used as a
denominator. This is a more specific computation of a company’s
profitability because the denominator being used is the one coming
from stockholders/owners alone.
Formula: Return on Equity = NIAT / Owner’s Equity
Using the GSM Company data, we would be able to compute the company’s
return on equity for 2018 and 2019.

2018 2019
Net Income After Tax 2,350,000.00 2,000,000.00
Divided by: Owner’s Equity 700,000.00 850,000.00
Return on Equity 3.36 2.35

Analysis: In 2019, the return on equity decreased. This could be

attributed to a lower net income after tax and a larger owner’s equity.

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 6. Asset Turnover Ratio
This ratio measures the correlation between the assets owned by the
company and the net sales generated by such properties.
Formula: Assets Turnover Ratio = Net Sales / Total Assets
Using the GSM Company data, we would be able to compute the company’s
assets turnover ratio for 2018 and 2019.
2018 2019
Net Sales 5,000,000.00 5,800,000.00
Divided by: Total Assets 2,300,000.00 2,700,000.00
Assets Turnover Ratio 2.17 2.15

Analysis: The assets turnover ratio slightly decreased in 2019. This is

something not good because the company should aim for a higher assets
turnover ratio. This can be attributed to bigger net sales generated for that
year.

What’s More

Activity 1.5.2 Compare and Contrast.

1. Compare and contrast liquidity ratio and solvency ratio.

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2. Compare and contrast profitability ratio and solvency ratio.

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