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MEASUREMENT LEVELS

• Financial ratios are one of the most common tools of managerial


decision making. A ratio is a comparison of one number to
another--mathematically, a simple division problem. Financial
ratios involve comparison of various figures from the financial
statements in order to gain information about a company's
performance. Ratios may serve as indicators, clues, or red flags
regarding noteworthy relationships between variables used to
measure the firm's performance in terms of profitability, asset
utilization, liquidity, leverage or market valuation.
TRADITIONALLY FINANCIAL
STATEMENTS ANALYSIS FOCUSES
ON THE FOLLOWING KEY AREAS:
1. LIQUIDITY
 The most common liquidity ratio is the current ratio, which is
the ratio of current assets to current liabilities. This ratio
indicates a company's ability to pay its short-term bills. A ratio of
greater than one is usually a minimum because anything less
than one means the company has more liabilities than assets.
Companies can improve the current ratio by paying down debt,
converting short-term debt into long-term debt, collecting its
receivables faster and buying inventory only when necessary.
2. SOLVENCY
 Solvency ratios indicate financial stability because it measures
a company's debt relative to its assets and equity. A company
with too much debt may not have the flexibility to manage its
cash flow if interest rates rise or if business conditions
deteriorate. The common solvency ratios are debt-to-asset and
debt-to-equity. The debt-to-asset ratio is the ratio of total debt to
total assets. The debt-to-equity ratio is the ratio of total debt to
shareholder's equity, which is the difference between total
assets and total liabilities.
3. STABILITY
 Stability is the long-term counterpart of liquidity. Stability
analysis investigates how much debt can be supported by the
company and wither debt and equity are balanced. The most
common stability ratios are the Debt-to-Equity ratio and
gearing(also called leverage).
4. PROFITABILITY
 Profitability ratios indicate management's ability to convert
sales into profits and cash flow. The common ratios are gross
margin, operating margin and net income margin. The gross
margin is the ratio of gross profits to sales. The gross profit is
equal to sales minus cost of goods sold.
5. EFFICIENCY
 Two common efficiency ratios are inventory turnover and
receivables turnover. Inventory turnover is the ratio of cost of
goods sold to inventory. A high inventory turnover ratio means
that the company is successful in converting its inventory into
sales.
FINANCIAL HEALTH OF THE
BUSINESS. THE MOST USED
METHODS ARE:
1. HORIZONTAL ANALYSIS
It analyzes the trend of the company's financials over a period of time. Each line item
shows the percentage change from the previous period.

2016 2015 VARIANCE %


Sales ₱ 3,000,000 ₱ 2,500,000 ₱ 500,000 20.0%
Statement of Performance

Cost of Goods Sold (1,600,000) (1,400,000) ( 200,000 ) (14.0%)


Gross Margin 1,400,000 1,100,000 300,000 27.0%
Operating Expenses
Salaries and Wages ( 575,000 ) ( 450,000 ) ( 125,000 ) (27.0%)
Office Rent ( 180,000 ) ( 150,000 ) ( 30,000 ) (20.0%)
Supplies ( 50,000 ) ( 40,000 ) ( 10,000 ) (25.0%)
Utilities ( 130,000 ) ( 100,000 ) ( 30,000 ) (30.0%)
Other Expenses ( 110,000 ) ( 90,000 ) ( 20,000 ) (22.2%)
Net Profit ₱ 355,000 ₱ 270,000 ₱ 105,000 38.9%
2016 2015 Variance %
Assets
Cash ₱ 235,000 ₱ 185,000 50,000 27.03%
Accounts Receivable 355,000 300,000 55,000 18.33%
Statement of Financial Position

Inventory 476,350 343,815 132,835 38.64%


Total Current Assets ₱ 1,066,350 ₱ 828,815 237,535 28.66%
Fixed Assets 847,450 900,000 ( 52,550 ) ( 5.38% )
Total Assets ₱ 1,913,800 ₱ 1,728,815 184,985 10.70%

Liabilities & Owner’s Equity


Accounts Payable ₱ 115,500 ₱ 177,745 ( 62,245 ) ( 35.02% )
Accrued Liabilities 17,385 25,155 ( 7,770 ) ( 30.00% )
Total Current Liabilities ₱ 132,885 ₱ 202,900 ( 70,015 ) ( 34.51% )
Notes Payable 800,000 900,000 (100,000 ) ( 11.11% )
Total Liabilities ₱ 932,885 ₱ 1,102,900 (170,015 ) ( 15.41% )

Owner’s Capital 980,915 625,915 355,000 56.71%


Total Liabilities & Owner’s Equity ₱ 1,913,800 ₱ 1,728,815 184,985 10.70%
2. VERTICAL ANALYSIS
 It compares the relationship between a single item on the Financial Statements to
the total transactions within one given period. It also shows the percentage of
change since the last period. It can be performed on both an Income Statement and
a Balance Sheet.

2016 %
Sales ₱ 3,000,000 100.00%
Statement of Performance

Cost of Goods Sold 1,600,000 53.33%


Gross Margin 1,400,000 46.67%
Operating Expenses
Salaries and Wages 575,000 19.17%
Office Rent 180,000 6.00%
Supplies 50,000 1.67%
Utilities 130,000 4.33%
Other Expenses 110,000 3.67%
Total Expenses 1,045,000 34.83%
Net Profit ₱ 355,000 11.83%
2016 %
Assets
Cash ₱ 235,000 12.28%
Accounts Receivable 355,000 18.55%
Inventory 476,350 24.89%
Statement of Financial Position

Total Current Assets ₱ 1,066,350 55.72%


Fixed Assets 847,450 44.28%
Total Assets ₱ 1,913,800 100.00%

Liabilities & Owner’s Equity


Accounts Payable ₱ 115,500 6.04%
Accrued Liabilities 17,385 0.91%
Total Current Liabilities 132,885 6.95%
Notes Payable 800,000 41.80%
Total Liabilites ₱ 932,885 48.75%

Owner’s Capital 980,915 51.25%


Total Liabilities & Owner’s Equity ₱ 1,913,800 100.00%
FINANCIAL RATIO
ANALYSIS
 Financial ratios are mathematical comparisons of financial
statement accounts or categories. These relationship between
the financial statement accounts help investors, creditors and
internal company management understand how well a business
is performing and of areas needing improvement.
1. LIQUIDITY RATIOS
 Liquidity ratios shows the cash level of a company and the
ability to turn other assets into cash to pay off liabilities and
other current obligations.
Here are the most common liquidity ratios :

• Current Ratio
The current ratio is liquidity and efficiency ratio that measures a
firm's ability to pay off its short-term liabilities with its current
assets.
Current Assets
Current Ratio =
Current Liabilities
Example :
Cash - Php10,000
Accounts Receivable - Php5,000
Inventory – Php5,000
Stock Investments – Php1,000 ₱10,000+₱5,000+₱1,000
1.07 =
Prepaid Taxes – Php500 ₱15,000
Current Liabilities – Php15,000
• Working Capital
The working capital measures a firm's ability to pay off its current
liabilities with current assets. The working capital is important to
creditors because it shows the liquidity of the company.

Working Capital Ratio = Current Assets – Current Liabilities


Example:
(₱25,000) = ₱100,000-₱125,000

 Current assets increase = Increase in working capital


 Current assets decrease = Decrease in working capital
 Current liabilities increase = Decrease in working capital
 Current liabilities decrease = Increase in working capital
2. SOLVENCY RATIOS
 Solvency ratios measure a company's ability to sustain operations indefinitely
by comparing debt levels with equity, assets and earnings. They are also called
leverage ratios. In other words, solvency ratios identify on-going
concerns/issues and a firm's ability to pay its bills in the long term.
The most common solvency ratio includes:

• Debt to Equity Ratio


The debt to equity ratio is a financial, liquidity ratio that compares a company's
total debt to total equity. A higher debt to equity ratio indicates that more
creditor financing (bank loans) is used than investor financing (shareholders).
Total Liabilities
Debt to Equity Ratio =
Total Equity
Example:
Assume that a company has ₱100,000 of bank lines of credit and a ₱500,000
mortgage on its property. The owners of the company have invested ₱1.2
million.

₱100,000+₱500,000
0.50 =
₱1,200,000

A debt ratio of .5 means that there are half as many liabilities as there is
equity.
• Equity Ratio
The equity ratio is an investment leverage or solvency ratio that measures the
amount of assets that are financed by owners' investments by comparing the
total equity in the company to the total assets.
Total Equity
Equity Ratio =
Total Assets
Example:
Tin's Tech Company is a new startup with a number of different investors. Tin is looking for
additional financing to help grow the company. Tin's total assets are reported at ₱150,000
and his total liabilities are ₱50,000. Based on the accounting equation, it can be assumes
that the total equity is ₱100,000. Tin's equity ratio:

₱100,000
0.67 =
₱150,000
• Debt Ratio
Debt Ratio is a solvency ratio that measures a firm's total liabilities as a
percentage of its total assets. In a sense, the debt ratio shows a company's
ability to pay off its liabilities with its assets. This shows how many assets the
company must sell in order to pay off all of its liabilities.
Total Liabilities
Debt Ratio =
Total Assets
Example:
Gino's Guitar Shop is thinking about an audition at the back of its existing building for more
storage. Gino consults with the banker about applying for a new loan. The bank asks for Gino's
statement of financial position to examine the overall debt levels. The banker discovers thta Gino
has total assets of ₱100,000 and total liabilities of ₱25,000. Gino's total debt ratio would:

₱25,000
0.25 =
₱100,000
3. EFFICIENCY RATIO
 Efficiency ratios also called activity ratio that measures how well companies
utilize their assets to generate income. Efficiency ratios often look at the time it
takes companies to collect cash from customer or the time it takes companies to
covert inventory into cash- in other words, make sales. These ratios are used by
management to help improve the company and also by outside investors and
creditors looking at the operations of profitability of the company.

• Accounts Receivable Turnover Ratio


Accounts receivable turnover ratio or activity ratio that measures how many times a
business can turn its accounts receivable into cash during a period. In other words, the
accounts receivable turnover ratio measures how many times a business can collect its
average accounts receivable during the year.

Net Credit Sales


Accounts Receivable Turnover Ratio =
Average Accounts Receivable
Example:
Lani’s ski shop is a retail store that sells outdoor skiing equipment. Lani offers accounts to all of
its main costumers. At the end of the year. Lani’s statement of financial position shows P20,000
in accounts receivable, P75,000 of gross credit sales and P25,000 of returns, Last year’s
financial showed P10,000 of accounts receivable.Lani’s accounts receivable turnover for the
ratio will be:

P75,000-P25,000
3.33 =
(P10,000- P20,000)/2
4.PROFITABILY
 Profitability ratio compare income statement accounts and categories to show a
company's ability to generate profits from it's operations. Profitability ratios focus
on a company's return on investment in inventory and other assets. These ratios
basically show how well companies can achieve profits from their operations.

• Gross Margin Ratio


Is a profitability ratio that compares the gross margin of a business to the net sales.
This ratio measures how profitable a company sells it's inventory or merchandise. In
short, the gross profit ratio is essentially the percentage mark-up on merchandise
from its cost . This is pure profit from the sale of inventory that can go to paying
expenses.
Gross Margin
Gross Margin Ration =
Net sales
EXAMPLE:
Assume Maricel's clothing store spent 100,000 on inventory for the year. Maricel was
able to sell this inventory for 500,000. Unfortunately, 50,000 of the sales were returned
by customer and refunded. Maricel's gross margin ratio will be:

(500,000 - 50,000) - 100,000


0.78 =
500,000 - 50,000

Maricel's gross margin ratio of 78 percent is a high ratio in the apparel


industry. This means that after Maricel pays off it's inventory costs, still it has
78 percent of the sales revenue to cover the operating costs