MODULE 3: Analysis and Interpretation

of Financial Statements 2

The object in analyzing financial statements is to assess the overall performance of

a business for a given period of time. The result of the analysis can serve as a basis for the
owner or management in making present and future plans or decisions. It can also be used
as a basis for evaluating the performance of the manager of the different departments of the
company.

Furthermore, financial analysis can demonstrate the strengths and weaknesses of

the business as it can determine the measurement level is, name the liquidity, solvency,
stability, and profitability.

In this module, we will discuss how financial statements deter mine the liquidity,
solvency, stability, and profitability of the business.

Content Course Competencies:

At the end of the module you will be able to demonstrate an understanding of the following:
 Measurement levels, namely liquidity, solvency, and profitability.
 Financial ratios such as current ratio, working capital ratio, gross profit margin ratio,
receivables turnover, and venture turnover, and depth to equity ratio.

Performance Course Competencies:

At the end of the module you will be able to:
 Solve exercise and problems that require computation and interpretation using
various financial ratios

Valuing Outcomes:
At the end of this module, you should be able to:
 Appreciate the practice of evaluating or reflecting on the simple things that you are
doing, which leads you to be a more competent and better person.
 Prepare yourself as a perfect candidate in the workforce in the future demonstrating
your competency as well as your Christian spirit.

Most essential learning outcomes:

At the end of this module, you should be able to:
 Define the measurement levels, namely liquidity, solvency, and profitability.
 Compute and interpret financial ratios such as current ratio, working capital ratio,
gross profit margin ratio, receivables turnover, inventory turnover, and debt to equity
ratio.
 Unit 1: Liquidity Ratios

Unit Learning Outcomes:

 Understand the different liquidity ratios.
 To be able to interpret the liquidity ratios.
 To be able to compute liquidity ratios given a company's financial
statements.

Thinking Activity

Your brother/ sister asked you to lend his/ her friend ₱1, 000. He/ she explains that
he/ she can’t lend any to his/ her friend as his /her friend allowance is almost finished.
Knowing that you have an allowance, he/she hopes that you can lend the amount from
his/her friend. Will you lend the amount to your brother/sister's friend? Why or why not?
What are the factors that you will consider before lending your money?

Write your answer/s here:

 You may have various answers.

 You may say you will let your brothers/sister’s front borrow your money if it is sure
that your money will be returned to you.

In this unit, we will be discussing the liquidity ratios, which may give a better
understanding on the ability of a company to pay its creditors.
 A liquid ratio is used to determine a company's ability to pay its short-term debt
obligations. It helps determine if a company can use its current or liquid assets to cover its
current liabilities. It calculates the company's current or quick assets against its outstanding
liabilities; generally, a high ratio indicates that the company has low risk of defaulting
payment.

The following are the common types of liquidity ratios:

1. Current Ratio
2. Quick Ratio
3. Receivable Turnover
4. Inventory Turnover
5. Working capital

Let's discussed each liquidity ratio and how they are being used in the businesses.

Types of Liquidity Ratios

1. Current Ratio
 Current ratio measures the ability of a business to pay its short-term
obligations as they fall due.

Current Assets
Current Ratio=
Current Liabilities

 As a general rule, a current ratio below one could indicate that a company
might struggle to meet its short-term obligations, whereas ratios of 1.50
or greater would generally indicate ample liquidity.

 Some banks and financial institutions require a current ratio of two or three
before extending credit in order to assume collection of the principal with
interest.

Let's see an example of interpreting current ratios.

2020 2021
Current Assets ₱ 665.4 ₱ 725.8
Current Ratio= = =1. 07 =1.32
Current Liabilities ₱ 620.6 ₱ 551.9

Fidas Merchandising
 Statement of Financial Position
As of December 31
(in millions)
2021 2020 2019
Assets
Current Assets
Cash ₱222.9 ₱330.2 290.0
Accounts Receivable ( Net) 285.5 172.1 156.0
Inventory 146.3 92.8 90.9
Prepaid Expenses 74.1 70.3 60.7
Total Current Assets ₱725.8 ₱665.4 ₱597.6
Property , Plant , And Equipment (Net) 1, 866.4 556.2 625.5
Total Assets ₱2, 592.2 ₱1, 221.6 ₱1, 223.1

Liabilities And Owner's Equity

Current Liabilities ₱551.9 ₱620.6 ₱580.7
Non-Current Liabilities 1, 822.4 376.6 4000.0
Total Liabilities ₱2, 374.3 ₱997.2 ₱980.7
Owner’s Equity 217.9 224.4 242.4
Total Liabilities And Owner's Equity ₱2,592 ₱1, 221.6 ₱1, 223.1

Fidas Merchandising
Statement of Comprehensive Income
As of December 31
(in millions)
2021 2020 2019
Net Sales ₱2, 213.3 ₱1, 738.7 ₱1, 543.2
Cost Of Goods Sold 1, 032.1 831.8 700.1
Gross Profit ₱1, 181.2 ₱906.9 ₱843.1
Selling And Administrative Expenses 889.2 659.5 555.5
Operating Income ₱292.0 ₱247.4 ₱287.6
Interest Expense 90.9 30.5 25.0
Income Before Income Taxes ₱201.1 ₱216.9 ₱262.6
Income Tax Expense (30%) 60.3 65.0 77.4
Net Income ₱140.8 ₱151.9 ₱185.2

Analysis:
a. Current ratio for 2020 is 1.07 to 1 while the 2021 is 1.32 to 1. This means that for
2020, the company has 1.07 current assets that can be converted to cash to pay
every peso of current liability while for 2021 the company has ₱1.32 of current
assets to cover every peso of current liability that will fall due.

b. Current ratio for 2021 increased signifying more liquidity for the company although
the company's satisfactory liquid in 2020.
 c. Analyzing components of current assets for 2021, Inventory and prepaid expenses
form only 30% of the current assets. Hence, the 70% is cash and receivable which
can readily be used to pay short-term liabilities.

2. Quick Ratio

Quick ratio is also known as the acid test ratio. It measures a company's short-term
liquidity position or a company's ability to meet its short-term obligations with its most liquid
assets. Meaning, the company has capacity to pay its current liabilities without needing to
sell its inventory or obtain additional financing.

The quick ratio is a more conservative measure of liquidity since it only considers
current assets that can be converted to cash easily or quickly. Quick ratio is defined as liquid
or quick assets divided by current liabilities.

Quick Assets
Quick Ratio=
Current Liabilities

Quick Assets Current Liabilities

 Cash  Obligations that must be paid

 cash equivalents (money market accounts , within one year
certificates of deposits , savings account ,  common account payables(
treasury bills that mature in 90 days) wages, Taxes , interest , utilities
 Marketable securities( bubbly publicly traded , insurance)
Stocks and bonds , commercial paper)  current portion of long-term
 receivables debt that must be paid in the
next year

Note: Currents assets such as inventory and prepaid expense ( such as prepaid
insurance), which cannot be quickly turned into cash are not considered quick assets.

Quick Ratio Formula

There are two ways to calculate quick ratio:

Current assets−inventories− prepaid expense

1. Quick Ratio=
Current Liabilities

cash+ cash equivalent +marketable securities+ accounts receivable

2. Quick Ratio=
Current Liabilities

Let’s set an example. The following table shows excerpts from the balance sheet of
Maginhawa Company. Calculate the company's quick ratio.
 Assets Amount
Current assets
Cash on hand ₱25,000
Cash in bank 15,000
Short term investments 30,000
Inventory 50,000
Accounts receivable 75000
Prepaid insurance 5,000
Total current assets ₱ 200,000
Noncurrent assets
Fixed assets ₱80,000
Goodwill 20,000
Total non-current assets ₱ 100,000

*Using equation 1, quick assets equals (200,000- 50,000- 5,000), or ₱145,000.

*Use equation 2, quick assets equals (25,000+ 15,000+ 30,000+ 75000), or ₱ 145,000.

The company has 160,000 current liabilities; thus, the quick ratio is calculated as follows:

Quick Assets 145,000

Quick Ratio= = =0.91
Current Liabilities 160,000

The quick ratio of Maginhawa Company is 0.91. It means to say that the company
can pay 91 centavos for every ₱1.00 of their current liabilities. Being less than 1; we cannot
immediately jump into conclusion that the ratio is unfavorable. A look into the company's
ratio in the past years may help as well as comparing with other companies in the industry.

3. Receivable Turnover

Receivable turnover is a measure of how quickly a company is collecting its sales

that were made on credit. Generally, a high ratio of receivable turnover is considered
favorable since it may indicate a company's strict credit policies with aggressive collection
efforts. On the other hand, a loan receivable turnover may indicate loose credit policies, are
inadequate collection effort.

We use the formula below to calculate receivable turnover.

Net Credit Sales

Receivable Turnover=
Average Trade Receivable

BegginingTrade Receivable+ Ending Trade Receivable

Average Trade Receivable=
2
Example:

2020 2021

₱ 1,738.7 10.6×₱ 2 , 213.3

Receivable Turnover= = =9.74׿
₱ 164.05 ₱ 227.3

₱ 156+ ₱ 172.1 ₱ 172.1+ ₱ 282.5

Average Receivable= =164.05 =227.3
2 2

Receivable turnover for the company are 10.6 times and 9.74 times for 2020 and
2021, respectively. This means that the company was able to collect its average receivables
10.6 times in 2020 and 9.74 times in 2021.

4. Inventory Turnover

Inventory turnover refers to the amount of time that inventory is sold during the
accounting period. It indicates whether the company holds excessive stocks of inventory.

For example:

The auditor of the company evaluates the inventory management of your business.
To assist her in this task, you gathered the following information from the accounting
records:

Merchandise inventory, January 1 2021 ₱ 325,000.00

Merchandise inventory, December 31 2021 ₱ 263,000.00
Cost of sales ₱1,524,000.0

Cost of Sales
Inventory Turnover=
Average Inventory

Beginning Inventory + Ending Inventory

Average Inventory= =294 , 000
2

1,524,000
Inventory Turnover= =5׿
294,000

To determine whether the inventory turnover is high or low, it must be compared

with the turnover rates of other companies within its industry.

As a general rule, the higher turnover, the more profitable it is for the company. On
the other hand, a low inventory turnover may signify a low demand on the products
prompting the company to make certain moves to market the products.

5. Working Capital

Working capital is also called net working capital (NWC). It is the difference between
a company's current assets and current liabilities. It shows the amount required to meet the
short term fund requirements of a company's operation.

The formula for working capital is:

Working Capital = Current Assets- Current Liabilities
For example:
Below is the working capital of Maginhawa Company (in millions)

2020 ₱665.40 - ₱620.60 = ₱44.80

2021 ₱725.80 - ₱551.90 = ₱173.90

The working capital of the Maginhawa Company is ₱44.8 million in 2020 and 173.9
million in 2021. This means that for 2021 the company is more liquid in meeting its short-
term obligations.

Working capital is a measure of a company's liquidity and short-term financial

health. A company has negative working capital if it's ratio of current assets to liabilities is
less than 1. Positive working capital indicates that a company can find its current operations
and invest in future activities and growth. Negative or low working capital may indicate a risk
of distress or default. However, high working capital may not always be good as it might
indicate that the business has too much inventory or is not investing its excess cash.

After discussing the liquidity ratios, let's deepen your understanding by recalling the
concepts and applications of each ratio. Try to analyze and interpret liquidity ratios using
sample financial statements below.

Total Pretty Beauty Salon

Comparative Statements Of Financial Position
As of 31 December 2021 and 2020
( In Philippine Peso)
Account 2021 2020
Assets
Current Assets
Cash ₱234,500.00 ₱245,000.00
Accounts Receivable 10,000.00 5,000.00
Prepaid Expenses 7,500.00 3,500.00
Total Current Assets 252,000.00 253,500.00
Noncurrent Assets 1,008,525.00 989,300.00
Total Assets ₱1,260,525.00 ₱1,242,800.00

Liabilities And Owner's Equity

Current Liabilities
Account Payables ₱125,000.00 ₱100,000.00
Non-Current Liabilities
Loans Payable 350,000.00 400,000.00
Total Liabilities 475,000.00 500,000.00

Owner's Capital
 Dureen Mayumi, Capital 785,525.00 742,800.00
Total Liabilities And Owner's Equity ₱1,260,525.00 ₱1,242,800.00
Total Pretty Beauty Salon
Comparative Statements Of Comprehensive Income
As of 31 December 2021 And 2020
( In Philippine Peso)
Account 2021 2020
Revenues
Hair Services ₱1,080,000.00 ₱998,500.00
Nail Services 785,500.00 495,600.00
Total Revenue 1,865,500.00 1,494,100.00
Expenses
Rent 240,000.00 240,000.00
Salaries 750,000.00 600,000.00
Depreciation 10,500.00 10,500.00
Utilities 120,000.00 109,000.00
Supplies 78,000.00 65,000.00
Advertising & Promotion 25,000.00 20,000.00
Taxes And Licenses 68,500.00 55,800.00
Repairs And Maintenance 12,475.00 4,500.00
Total Expenses 1,304,475.00 1,104,800.00
Operating Income 561,025.00.00 389,300.00
Less: Interest Income 10,500.00 0.00
Net Income Before Tax 550,525.00 389,300.00
Less: Income Tax 67,631.00 27,860.00
Net Income After Tax ₱482,894.00 ₱361,440.00

Note: Net Credit Sales is 30% of Revenue

Answer:

1. Working capital = current assets - current liabilities

Year working capital

2021 252,000.00 - 125,000.00 = 127,000.00
2020 253,500.00 - 100,000.00 = 153,500.00

2. Current ratio = current assets/ current liabilities

Year current ratio

2021 252,000.00/125,000.00 = 2.01 : 1:00
2020 253,500.00/100,000.00 = 2.54 : 1:00

3. Acid test quick ratio= quick assets/ quick liabilities

Year current ratio

2021 252,000.00/125,000.00 = 2.01 : 1:00
2020 253,500.00/100,000.00 = 2.54 : 1:00
4. accounts receivable turnover= net credit sales/ average accounts receivable

Year Average Accounts Receivable

2021 559,650.00/7,500.00 = 75 times
2020 Not applicable
The average accounts receivable cannot be computed for 2020 since data for
2019 were not available.

5. inventory turnover= cost of sales/ average inventory

Note: The inventory turnover cannot be computed for both years since data on cost of
sales and inventories were not available in the given financial statements.

6. operating cycle= collection period (days) + Average of inventory (days)

Where:

Collection period= 365 days/ accounts receivable turnover

Average age of inventory= 365 days/ inventory turnover

Note: This is not applicable for this company as it is not a merchandising business
period