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Analysis and Interpretation - Ballada-Part 2

Ratio analysis compares indicators to provide insight into a company's performance. Ratios express the mathematical relationship between quantities and can be percentages, rates, or proportions. Managers use ratios to understand a company's health. Ratios are classified into liquidity ratios, which measure ability to pay current liabilities; profitability ratios, which measure ability to earn profit; and solvency ratios, which measure long-term survival ability. Examples of key liquidity, profitability, and solvency ratios and their purposes are discussed.

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Claire Evann Villena Ebora
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281 views

Analysis and Interpretation - Ballada-Part 2

Ratio analysis compares indicators to provide insight into a company's performance. Ratios express the mathematical relationship between quantities and can be percentages, rates, or proportions. Managers use ratios to understand a company's health. Ratios are classified into liquidity ratios, which measure ability to pay current liabilities; profitability ratios, which measure ability to earn profit; and solvency ratios, which measure long-term survival ability. Examples of key liquidity, profitability, and solvency ratios and their purposes are discussed.

Uploaded by

Claire Evann Villena Ebora
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Ratio Analysis

 It compares one indicator to another.


 Ratios can give significant insight into the performance and relative importance of two indicators.
 A ratio, which may either, be a percentage, a rate, or simple proportion, expresses the
mathematical relationship between one quantities and another.
 Managers and investors can use ratio analysis to understand the health of an entity.

CLASSIFICATION OF RATIOS: LIQUIDITY, PROFITABILITY AND SOLVENCY RATIOS


LIQUIDITY RATIOS - measuring the ability to pay current liabilities
 Creditors and potential creditors are interested in continuously monitoring an entity’s ability to
pay interest as it comes due and to repay the principal of the debt at maturity.
 An analysis of a firm’s liquid position provides indicators of its short-term debt-paying ability.

A. Working Capital – it describes the amount of capital used to run day to day business operation. It is the
difference between current assets and current liabilities. It is a measure of the liquid resources that
management will control in the short term.

Example:

Current Assets P 109,292,000


Less: Current Liabilities (39,033,000)
Working Capital 70,259,000

 LOW AMOUNTS of working capital can indicate that the business is insufficiently liquid and could
have problems meeting current liabilities.
 VERY HIGH working capital amounts could indicate ineffective management since current assets
seldom yield returns as great as long term assets.
 A STRONG working capital is an indication that a firm will be able to make its expected dividend
and interest payments in a timely manner.

B. Current Ratio – describes the ability of an entity to meet current debt obligations with assets that are
readily available.

Example:

Current assets P 109,292,000


Current ratio = Current Liabilities 39,033,000
2.8
 This means that for every peso of current liabilities, an entity has 2.9 peso of current assets.
 HIGHER RATIOS indicate an increased ability to pay short term obligations such as accounts
payable and interest payment.
 LOWER RATIOS can indicate an inability to meet short term obligations, which could lead to
insolvency and bankruptcy.
 VERY HIGH CURRENT RATIOS much in excess of 2 peso, can indicate that an entity is not using its
assets in an ideal manner.
 A HEALTHY current ratios equal or exceed the value of 2 peso.
C. Quick Ratio – It tells whether the entity could pay all its current liabilities even if none of the inventory
is sold. Quick assets are those that may be converted directly into cash within a short period of time (cash,
trading investments and receivables. Inventory is omitted because merchandise is normally sold on credit.
Prepaid expenses are also omitted because they are usually relatively small in amount and they are used
up in operations rather than converted into cash.

Example:

Cash P 5,368,000
Trading Investment 3,090,000
Accounts Receivable 35,382,000
TOTAL QUICK ASSETS P 43,840,000

Current assets P 43,840,000


Quick ratio = Current Liabilities 39,033,000
1.12
 A STRONG quick ratio should be at least 1:1

D. Accounts Receivable Turnover – it measures the entity’s ability to collect from credit customers. It
indicates the # of times that the average balance of accounts receivable is collected during the period.

Accounts Receivable Net credit sales P 862,915,000 Average A/R is compute by adding
Turnover = Average A/R (32,936,000 + 35,382,000) / 2 the beginning and ending
balances of the A/R and dividing it
25.3
by 2.
 The higher the ratio, the more successfully the business collects cash.
 A turnover that is TOO HIGH may indicate the credit is too tight, causing the loss of sale to good
customers.

E. Average Age of Receivable – it provides a rough approximation of the average time that it takes to
collect receivables.

Average Age of 365 days 365 days


Receivables Accounts Receivable 25.3
Turnover
14.4 days
 The general rule is that the collection period should not materially exceed the credit period.

F. Inventory Turnover – is a measure of the number of times an entity sold its average level of inventory
during the period.

Inventory Turnover COGS 564,346,000 Average Inventory is compute


Average Merchandise (50,434,000 + 62,582,000) / by adding the beginning and
ending balances of the
Inventory 2
Inventory and dividing it by 2.
9.99 times
 A high rate of turnover indicates ease in selling inventory. However, a high value means that the
business is not keeping enough inventories on hand and thus may result to lost sales.
G. Average Age of Inventory – it provides a rough measure of the length of time it takes to acquire, sell
and replace inventory.

Average Age of 365 days 365 days Average Inventory is compute


Inventory Inventory Turnover 9.99 by adding the beginning and
ending balances of the
365.54 days
Inventory and dividing it by 2.

H. Operating Cycle – it measures the average time period between buying the inventory and receiving
cash proceeds from its sales. It is determined by adding the average age of inventory and the average age
of receivables.

PROFITABILITY RATIOS - measuring the ability to earn profit


A. RETURN ON TOTAL ASSETS – is the measure of management’s efficiency in using its assets to earn
profits.

Return on total Profit + interest expense 17,575 + 3,120 Average total asset is compute
assets Average total assets ( 156,625 + 172,583)/2 by adding the beginning and
ending balances of the total
12.57 %
asset and dividing it by 2.
 The result means that the entity earned an average of 12.57% on every peso invested

B. RETURN ON TOTAL EQUITY – shows the relationship between profit and equity. The goal is to have a
higher return on equity

Return on total Gross profit 20,695 Average SHE is computed by


equity Average share holder’s ( 50,000 + 57,500)/2 adding the beginning and
ending balances of the total
equity
equity and dividing it by 2.
19.25 %

SOLVENCY RATIOS - measuring the ability of the entity to survive over a long period of time.
A. TIME INTEREST EARNED RATIO – is the measure of how readily an entity can meet interest payments
with profit earned from the operations.

Time Interest Earned Profit before interest 30,158.462


expense and income tax
Annual interest expense 3,120,000
9.7 times
 The times interest earned ratio indicates the margin of safety provided by current earnings.
 The profit of the entity available to meet its interest responsibilities was way over 9 times the
amount of its interest expense.
B. DEBT TO TOTAL ASSETS RATIO – shows the percentage of the entity’s assets financed by debt.

Debt to total assets Total liabilities 69,033,000


Total assets 172,583,000
40%
 Higher ratios indicate that an entity has finances a large portion of assets with debt. In this case,
creditor risk increases because there is less margin available if the entity must liquidate its assets.
 The results means that 40% of the total assets were financed by debt

C. EQUITY TO TOTAL ASSETS RATIO – shows the percentage of the entity’s assets financed by
shareholders.

Equity to total assets Total Equity 103,550,000


Total assets 172,583,000
60%
 The higher the ratio, the smaller the risk that an entity will be unable to meet its obligation when
due.
 The result above means that 60 % of the total assets were financed by the shareholders and 40%
were financed by debt. This ratio should be satisfactory to long term creditors.

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