SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY
Accountancy Department
LMS ACTIVITIES - SHORT TERM 2020
Week 2 – June 15-19, 2020
Course
FMGT 1013 – Financial
Management
Code
031, 033, 034
032, 035, 037
036
Teacher
Jerome D. Marquez
Rovelle Concepcion S. Siazon
Rommel Royce V. Cadapan
FINANCIAL STATEMENT ANALYSIS, PART 2
DISCUSSION
Follow-Up and Recap:
The result of your 15-minute asynchronous pre-test shows that you have reasonable knowledge on the presentation of
financial statements including a good grasp about the nature of the accounts and line items. As I said, this is your foundation
to financial statements analysis. Good job on that! Keep it up!
I hope, by this time, you have already finished your Exercises – Part 1 on the following areas:
a. Horizontal analysis of Comparative Statements (Increase-Decrease Method)
b. Trend Analysis
c. Vertical Analysis or Common Size Financial Statements
Ok, let’s have a quick recap of the first three techniques of financial statements analysis:
It is illogical to compare the financial statements of a single company from one period to another period or to compare one
company to another company within the same industry by looking on the peso value as reflected in the financial statements.
When comparing two companies, one may have a higher net income simply because it is bigger and not because it is more
efficient, effective or sells a better product. Or, in comparing financial statements over several accounting periods for a single
company, we may find that its sales may grow significantly during one of the periods, making comparison difficult. One of
the ways to deal with these size differences is through comparative financial statement analysis.
Comparative financial statement analysis states each item of the financial statement not as a numerical amount (i.e., peso
value), but rather as a percentage of a relevant base amount.
Comparative financial statements can be either vertical or horizontal.
 Vertical analysis (also called common-size financial statements) makes it possible to compare the performance
of companies of different sizes during the same period of time.

Horizontal and trend analysis enables comparison of data for a single company or single industry over a period
of time.
Your analysis does not end on computation of percentages. It should be interpreted in such a way that would give
enlightenment on the following major concerns:
a. Short-term solvency;
b. Long-term financial position; and
c. Profitability.
Ok guys! Ready ka ng i-explore ang Financial Ratio Analysis? Mag-set ako ng expectations dito a. Sa topic na ‘to,
napakadaming formulas na makikita mo. Pero, gaya ba ‘to ng formulas na minemorize mo sa IA series like Present
Value and Future Value factors? Sir, kailangan din ba naming i-memorize ang mga formula sa pagcompute ng iba’t
ibang financial ratios? Sir, andami, bakit ganun?
Ang kasagutan: Dapat ready kana! In practice, like ako, mas nagiging malakas ang conviction ko to invest or add
additional investment or ibenta ang current holdings ko ‘pag may developments sa financial ratios. Ang
kagandahan kasi ng financial ratios, sa mismong pangalan pa lang nung formula, say for example: CURRENT RATIO
or QUICK/ACID TEST RATIO, may idea kana kung ano ang pinapahiwatig nung “ratio” na nacompute. The term
itself, e.g., Current Ratio, gives you already an idea that it refers to current items (current assets and current
liabilities). But since it requires a “ratio”, it should connote “RELATIONSHIP”. In other words, anu kaya ang relasyon
ng current assets sa current liabilities? Nakukuha mo pinapahiwatig ko?
So kailangan mo bang i-memorize? I believe the memorization issue is consequential. I am not fond of memorizing
per se. Kung nakuha mo ang gist ng “Current Ratio”, ibig sabihin alam mo yung concept niya (concept-based
learning), hinding hindi mo na alalahanin pa ang formula. Parang natural na lang na mabubuo sa utak mo yung
formula.
Napakadaming “relasyon” ang meron sa financial ratio analysis. Huwag ka ng dumagdag pa…charrr Basta guys,
ang susi sa topic na ‘to – unawain mo yung KONSEPTO behind the ratio/formula. Kahit memorize mo pa ang lahat
ng formula sa financial ratios, kung hindi mo naman alam i-interpret ang mga ito, para ka ding pumasok sa isang
relasyon para lang masabi ng iba na may jowa ka. Instead, dapat alam mo ang commitments and consequences
kung bakit ka pumasok sa isang relasyon. Sa ibang pangungusap, LALIMAN natin ang pagintindi sa mga bagaybagay. Tanungin natin lagi ang sarili natin kung na-coconfuse na tayu, BAKIT? BAKIT? BAKIT?
Another thing on this topic. Napaka-technical ng part na ‘to. Napakadaming jargons, pero sure ako karamihan ng
mga figures na gagamitin sa pag-compute ng certain ratio ay alam mo like EBIT, Operating Cycle, Dividends,
Outstanding Shares, “Average” (Beginning Balance + Ending Balance / 2), Fixed Costs, Operating Cash Flow, etc…
New Topic:
FINANCIAL RATIO ANALYSIS
It is the process of looking at the relationships between different numbers in the financial statements to see if they indicate
positive or negative trends developing within a company.
 A firm’s equity investors, potential equity investors and stock analysts as well as its creditors use ratios calculated
from the firm’s financial statements to make investment and credit decisions.
 While the ultimate purpose of ratio analysis is to enable evaluation of risk and return, different users need different
information.
Examples:
1. Short-term creditors, such as banks and trade creditors, use ratios to determine the firm’s immediate
liquidity.
2. Longer-term creditors such as bondholders use ratios to determine a firm’s long-term solvency.
3. Both short-term and long-term creditors use financial statement analysis to gain assurance that the firm has
the necessary resources to be able to pay its interest and principal obligations.
4. Equity investors use ratios to determine the firm’s long-term earning power. The equity investors’ analysis
needs to be more in-depth than the creditors’ analysis, because equity investors bear the residual risk of
the company. The equity investors’ claims on the company’s funds are settled only after the claims of
suppliers and lenders are settled.
 Ratios are based on accounting data. Because of the fact that the accounting system uses historical costs rather
than current fair market values, ratios often do not reflect the current values of the items they are measuring.
 When we calculate a ratio, all we get is a number. In order for this number to be meaningful, we need to put it
into some kind of context by comparing it with another number. We can make these comparisons through:
1. Trend analysis of a single company by comparing current ratios to previous years’ ratios. Trends can
be particularly useful in analyzing a firm’s financial condition. For example, ratios that are becoming less
favorable over time may be an indication of financial difficulty. The financial difficulty may not yet be
apparent, but if the ratios do not improve, it will manifest itself in the future. Ratio analysis can thus provide
an early warning of trouble ahead.
2. Comparison with other companies in the same industry or with industry averages after any necessary
adjustments have been made to assure that the financial statements are comparable. If a company’s ratios
are less favorable than those of other companies in its industry, the company will not be able to compete
successfully in its market.
3. Comparison with management’s expectations. If the entity set a target current ratio of 2:1 this current year,
but it turned out to be 1.5:1, this could be considered an area of concern by the management since actual
result is below than the targeted one. It could be attributed to inefficiency of managing current resources.
Sana guys naunawaan mo yung concepts and significance of financial ratio analysis. Ganun siya kapowerful. Ikaw
na primary user ng financial statements (i.e., Existing and potential creditor and existing and potential investor),
napakalaking tulong talaga ng FS ratios. Kaya nga pag ang isang kumpanya gustong mangutang sa BPI o anumang
bank lalu na kung napakalaking halaga, ang bangko humihingi ng audited FS sa potential borrower. Para saan?
Obviously, para i-assess ang financial health ng potential borrower.
Ok, pero ito na ang pinakahihintay niyo. Hindi ko na kayu bibitinin pa.
The classification of financial ratios here is based on CMA curriculum. You may encounter other resources with different
classifications, but I find this categorization more accurate. You may also encounter from your textbooks or review materials
different term or label of a certain financial ratio. If this is the case, try to reconcile them. If you are still confused, PM is the
key.
First, I would like you to have a bird’s eye view of the various financial ratios including a brief but concise concepts and their
respective formulas so that you will have a guide later in applying these ratios in the comprehensive illustrative case.
Liquidity ratios - they measure the sufficiency of the firm’s cash resources to meet its short-term cash obligations.
A.
Concept and Significance
Formula


1.
Current Assets
Current Liabilities
Current Ratio

2.
Quick Ratio or Acid
Test Ratio
3.
Cash + Marketable Securities + Net
Accounts Receivable
Current Liabilities
Cash & Cash Equivalents +
Marketable Securities
Current Liabilities
Cash Ratio





4.
Operating Cash Flow
Period-End Current Liabilities
Cash Flow Ratio


5.
Cash Flow Liquidity
Ratio
Cash & Cash Equivalents +
Marketable Securities + Operating
Cash Flow
Current Liabilities
Measures short-term liquidity by considering cash resources
plus cash flow from operating activities.


6.
Net Working Capital
Ratio
Net Working Capital (Current Assets –
Current Liabilities)
Total Assets


7.
B.
Defensive Interval
Ratio (DIR) or Basic
Defense
Interval
(BDI)
Cash + Marketable Securities + Net
Accounts Receivable
Projected Daily Operating Expenses
The most commonly used measure of short-term liquidity
Measures a company's ability to pay short-term
obligations or those due within one year. It tells investors
and analysts how a company can maximize the current
assets on its balance sheet to satisfy its current debt
and other payables.
The standard for the current ratio is 2:1. A lower ratio
indicates a possible liquidity problem.
A more conservative version of the current ratio
Compares a company's most short-term assets to its
most short-term liabilities to see if a company has
enough cash to pay its immediate liabilities, such as
short-term debt. Inventories and prepaid expenses are
excluded from the numerator.
Is even more conservative than the quick ratio.
A measure that shows a company's ability to cover its
short-term obligations using only cash and cash
equivalents including marketable securities.
Compares the cash flow generated by operations with
current liabilities and measures how many times greater
the cash flow generated by operations is than current
liabilities.
If a company has positive working capital but it is not
generating enough cash from operations to settle its
obligations as they become due, the company is
probably borrowing to settle current liabilities.
Using cash flow as opposed to net income is considered
a cleaner or more accurate measure since earnings
are more easily manipulated.


Compares net liquid assets (net working capital) to total
capitalization (total assets) and measures the firm’s
ability to meet its obligations and expand by maintaining
sufficient working capital.
The net working capital ratio is particularly meaningful
when compared with the same ratio in previous years,
especially if it is decreasing. Consistent operating
losses will cause net working capital to shrink relative to
total assets.
If working capital is negative (current liabilities are
greater than current assets), the net working capital ratio
will also be negative. Negative working capital and a
negative net working capital ratio are indicators of very
serious problems.
A financial metric that indicates the number of days that
a company can operate without needing to access
noncurrent assets, long-term assets whose full value
cannot be obtained within the current accounting year, or
additional outside financial resources.
Alternatively, this can be viewed as how long a
company can operate while relying only on liquid
assets.
There is no specific number that is considered the best
or right number for a DIR. It is often worth comparing the
DIR of different companies in the same industry to get
an idea of what is appropriate, which would also help
determine which companies could be better investments.
Leverage, capital structure, solvency and earnings coverage ratios – they evaluate the firm’s ability to satisfy its debt and
obligations for other fixed financing charges such as operating leases by looking at the mix of its financing sources and its historical
earnings.
1.
Leverage in general refers to the potential to earn a high level of return relative to the amount of cost expended.

a.
Financial
Leverage
Ratio,
Equity
Multiplier

or
Total Assets
Total Equity

Financial leverage is the use of debt to increase
earnings. The cost of using debt is called interest.
Financial leverage magnifies the effect of both
managerial success (profits) and managerial failure
(losses). When financial leverage is being used, an
increase in earnings before interest and taxes (EBIT)
will cause an even greater proportionate increase in net
income, and vice versa.
Financial leverage ratios measure a company’s use of
debt to finance its assets and operations.



b.
Degree
of
Financial
Leverage
(DFL)
(2 periods and
1
period,
respectively)
% [of future] Change in Net income
% [of future] Change in EBIT (Earnings
Before Interest and Taxes)
OR
Earnings Before Interest and Taxes
(EBIT)
Earnings Before Taxes (EBT)


c.
d.
2.
3.
Degree
Operating
Leverage
Degree
Total
Leverage
of
of
% [of future] Change in EBIT
% [of future] Change in Sales
OR
Contribution Margin
EBIT
% [of future] Change in Net Income
% [of future] Change in Sales
OR
Contribution Margin
Earnings Before Taxes (EBT)


Financial leverage is successful if the firm earns more
by investing the borrowed funds than it pays in interest
to use them. It is not successful if the firm is not able to
earn more by investing the borrowed funds than it pays
in interest for them.
Is the factor by which net income can be expected to
change in the future in relation to a future change in
earnings before interest and taxes (EBIT), since interest
on debt is a fixed expense.
The degree of financial leverage is the ratio by which
earnings before taxes (EBT) will change in response to
a change in earnings before interest and taxes
(EBIT), assuming that interest expense does not change.
When financial leverage is used, a given percentage
increase in EBIT will result in an even greater
percentage increase in EBT, because interest expense
(the difference between EBIT and EBT) is a fixed
expense. Once interest expense has been covered by
EBIT, further increases in EBIT flow straight to EBT.
However, the opposite is also true: a given percentage
decrease in EBIT will result in an even greater
percentage decrease in EBT.
Just as financial leverage measures the use of fixed
interest expense charged on debt financing to generate
greater returns for equity investors, operating leverage
measures the use of fixed operating costs to
generate greater operating profit.
Is the ratio by which earnings before interest and taxes
(EBIT) will change in response to a change in sales,
assuming the contribution margin ratio and fixed
operating costs do not change.
Operating leverage refers to the fact that, for a given
level of fixed expenses, a given percentage change in
sales will result in a higher percentage of change in
profits.
Expresses the degree to which a company uses fixed costs
in its operations as well as the degree to which the company
uses fixed rate financing in its capital structure.
Capital structure refers to the way a firm chooses to finance its business.
Solvency is the ability of the company to pay its long-term obligations as they come due.

Is a comparison of how much of the financing of assets
comes from creditors with the amount of financing that
comes from owners in the form of equity.

A debt to equity ratio of 2.00, or 2:1, for example, means
that the company’s total debt is twice its total equity, or
its debt financing consists of $2.00 of debt for every
$1.00 of equity.

The debt to equity ratio can serve as a screening
device for the analyst when looking at capital structure
Total Liabilities
a. Debt to Equity
ratios. If this ratio is extremely low (for instance, 0.1:1),
Ratio
Total Equity
then there is no need to calculate other capital structure
ratios because there is no real concern with this part of
the company’s financial situation. The analyst’s time
could be better spent looking at other aspects of the
company’s operations. However, if the debt to equity
ratio is in the neighborhood of 2:1 or higher, it would be
important to do some extended analysis that focuses
on other ratios such as profitability, as well as the
company’s future prospects.
b.
Long-Term
Debt to Equity
Ratio
Total Debt − Current Liabilities
Total Equity
c.
Debt to Total
Assets Ratio
Total Liabilities
Total Assets
Measures how much long-term debt a company has
compared to its total equity.
Measures the proportion of the company’s total assets that
are financed by creditors, an indication of the firm’s long-term
debt repayment ability
Earnings coverage ratios focus on the company’s earning power, because the company’s earnings are the source of its
ability to make interest payments and principal repayments on debt.
a. Interest

Compares the funds available to pay interest (earnings
Earnings Before Interest and Taxes
Coverage
before interest and taxes) with the amount of interest
(EBIT)
(Times
expense on the income statement and gives an
Interest
indication of how much the company has available for
Interest Expense
Earned) Ratio
the payment of its fixed interest expense.
Earnings Before Fixed Charges and
Taxes*
Fixed Charges**
b.
Fixed Charge
Coverage
(Earnings to
Fixed
Charges)
Ratio
* EBIT (Earnings Before Interest and
Taxes)
+ Add back operating lease payments
expensed
**Interest expense on loans and
capital leases
+ Required principal payments on
loans and capital leases
+ Total payments on operating leases

A high interest coverage ratio is desirable. An interest
coverage ratio of greater than 3.0 is excellent. When the
interest coverage ratio gets down to 1.5, the company
has a heightened risk of default. The further the ratio
declines below 1.5, the higher the risk of default
becomes.

Measures a firm's ability to cover its fixed charges, such
as debt payments, interest expense and equipment
lease expense and shows how well a company's
earnings can cover its fixed expenses.
A fixed charge coverage ratio of 4.0 is excellent. It
means the company has four times as much in earnings
as it needs in order to fulfill its contractual obligations to
make interest and principal payments on its loans and
capital leases and to make its operating lease payments.

Adjusted Operating Cash Flow*
Fixed Charges
c.
C.
Cash Flow to
Fixed
Charges Ratio
*Cash flow from operations (from the
Statement of Cash Flows)
+ Cash Fixed Charges (to add back
cash interest paid on loans and capital
leases and operating lease payments,
since those items are deducted in
calculating cash flow from operations)
+ Cash Tax Payments (cash amount
paid in taxes, a disclosure on the SCF)
Tells us a little more about availability of cash to fulfill
contractual financing obligations than the fixed charge
coverage ratio does, because it uses operating cash flow.
The cash flow to fixed charges ratio tells us how much in
operating cash flow the company has available to pay its
contractual obligations.
Activity ratios - they provide information on a firm's ability to manage efficiently its current assets (accounts receivable and
inventory) and current liabilities (accounts payable).
1.
Accounts Receivable Activity Ratios

2.
Measures the number of times receivables “turn over”
during a year’s time, or are collected and are replaced
with new receivables. It tracks the efficiency of a firm’s
accounts receivable collections and indicates the amount
a. Accounts
of investment in receivables that is needed to maintain
Net Annual Credit Sales
Receivable
the firm’s level of sales.
Turnover
Average Gross Accounts Receivable

By comparing the accounts receivable turnover ratio
Ratio
from year to year for one company, we can see how the
company’s collection rate changes over time. An
increase in the accounts receivable turnover ratio
indicates that receivables are being collected more
rapidly. A decrease indicates slower collections.

Measures the average number of days that it takes a
company to collect payment after a sale has been
made.

The accounts receivable turnover ratio and days sales in
receivables, or average collection period, should be
365
b. Days Sales in
compared with industry averages, with previous
Receivables Turnover Ratio
Receivables
periods’ amounts for the same company, and with the
OR
(Average
company’s credit terms. The number of days of sales in
Average Gross Accounts Receivable
Collection
receivables should not be higher than the standard
Average Daily Net Credit Sales (Net
Period)
credit terms offered by the company. An average
Annual Credit Sales ÷ 365)
collection period that is higher than the standard credit
terms offered may indicate poor collections efforts,
customer dissatisfaction leading to refusal to pay,
customers in financial distress or an extreme delay of
payment by one or two large customers.
Inventory Activity Ratios - The inventory activity ratios will be affected by the company’s choice of inventory valuation
methods (FIFO, WAM, etc.), too. Thus, they may not be useful for comparing companies when the companies use different
inventory valuation methods.

Indicates how many times during the year the
company sells its average level of inventory.

Measures both the quality of the inventory and the
liquidity of the inventory. Both quality and liquidity of
inventory give an indication of the salability of the
inventory.
a. Inventory
Annual Cost of Goods Sold

If a company has a high inventory turnover ratio, it
Turnover
Average
Inventory
may mean the company is using good inventory
Ratio
management and is not holding excessive amounts of
inventories that may be obsolete, unmarketable goods.
However, it can also mean that the company is not
holding enough inventory and may be losing sales, if
prospective customers are unable to make purchases
because items are out of stock.
b.
3.
Days Sales in
Inventory
365
Inventory Turnover
OR
Average Inventory
Average Daily Cost of Sales (Annual
Cost of Sales ÷ 365)
Represents the average number of days that inventory
items remain in stock before being sold, or the average
number of days required to sell an item of inventory.
Accounts Payable Activity Ratios - indicate the speed with which the company pays its suppliers.

a.
b.
4.
Accounts
Payable
Turnover
Ratio
Days
Purchases in
Accounts
Payable
Annual Credit Purchases
Average Accounts Payable
Average Accounts Payable
Average Daily Credit Purchases
(Annual Credit Purchases ÷ 365)
OR
365
Accounts Payable Turnover



Represents the average number of days the company
takes to pay its payables.
An increase in the number of days purchases in
payables indicates that the company is paying its
payables more slowly, which could mean the company
is having liquidity problems
Operating Cycle and the Cash Cycle
a.
Operating
Cycle
Days Sales in Receivables + Days
Sales in Inventory
Is the length of time it takes to convert an investment of
cash in inventory back into cash through collections of the
receivables resulting from sales made



b.
Cash cycle or
Cash
Conversion
Cycle or Net
Operating
Cycle
Operating Cycle – Days Purchases in
Accounts Payable
OR
Days Sales in Receivables + Days
Sales in Inventory – Days Purchases
in Accounts Payable


D.
Represents the number of times payables “turn over,”
or are paid and new ones are generated by new
purchases, during a year’s time.
A decrease in the accounts payable turnover ratio over
time means the company is paying its payables more
slowly, an indication of possible liquidity problems.
5.
Total
Asset
Turnover Ratio
Sales
Average Total Assets
6.
Fixed
Asset
Turnover Ratio
Sales
Average Net Property, Plant and
Equipment

Is the length of time it takes to convert an investment of
cash in inventory back into cash, recognizing that some
purchases are made on credit.
In a large company, a small reduction in the cash cycle
can increase pretax profits significantly because of the
lowered costs of financing.
Some companies may actually have negative cash
cycles. A company that manufactures its product on
demand and requires its customers to pay by credit
card before it ships can have a negative cash cycle if it
is granted terms from its own suppliers. The company’s
days sales in receivables are basically zero, its days
sales in inventory are very low since it manufactures
product only on demand, and its days purchases in
payables are probably the highest number of all three.
That situation creates a negative cash cycle.
If a company has a negative 50 day cash cycle, for
instance, it means the company converts each sale to
cash 50 days before it needs to pay the invoices from its
suppliers for the cost of the sale. Having a negative
cash cycle is a very favorable position for a
company to be in.
Measures the amount of sales revenue the company is
generating from the use of each currency unit it has in
total assets.
The total asset turnover ratio provides a means of
measuring the overall efficiency of the company’s use
of all its investments, including both current assets and
non-current assets.
Measures the amount of sales revenue the company is
generating from each currency unit of only its fixed assets.
Profitability analysis - measures the firm’s profit in relation to its total revenue or the amount of net income from each dollar of
sales and its return on invested assets.



1.
Gross
Profit
Margin
Percentage
Gross Profit
Net Sales

Measures the percentage of the sales price available
to cover fixed and nonmanufacturing costs.
The company’s gross profit margin is the key to its
overall profitability.
Changes in the gross profit margin are usually due to
one or more of the following:
o sales volume increases or decreases,
o unit selling price increases or decreases, and
o increases or decreases in cost per unit.
A low gross profit margin can be an indication that
employee theft is taking place. For example, if the gross
profit margin for a restaurant is lower than the industry
norm but the restaurant’s prices are in line with other
restaurants’ prices, it could mean that steaks are “going
out the back door.”
2.
Operating Profit
Margin
Percentage
Operating Income
Net Sales
Measures how much of its sales revenue the firm keeps as
operating income.

3.
Net Profit Margin
Percentage
4.
EBITDA
Margin
Percentage
(Earnings
Interest,
Depreciation
Amortization
EBITDA)
Net Income
Net Sales
Before
Taxes,
and
or
EBITDA
Net Sales

Illustrates how much of each dollar in revenue collected
by a company translates into profit.
Vertical analysis (common size financial statements) and
horizontal analysis (common base year statements) can
be helpful in detecting causes of variations in the net
profit margin from year to year.
Measures a company's operating profit (EBITDA) as a
percentage of its revenue.

E.
5.
Return on Assets
(ROA)
Net Income
Average Total Assets
6.
Return on Equity
(ROE)
Net Income
Average Total Equity
7.
Return
Common
Equity
on
Net Income – Preferred Dividends
Average Common Equity
Measures how much return the company receives on the
capital it has invested in assets and thus it measures
the company’s success in using financing to generate
profits.

Probably the most widely recognized measure of
company performance.

An analyst can compare the return on assets of a
company with the returns of alternative investments,
such as government bonds. Since the return on
government bonds is considered to be risk-free,
comparison of the company’s ROA with the government
bond’s rate of return can provide an indication of whether
an adequate risk premium is being earned by investors
to compensate them for the risk they are assuming in
that particular investment.
Measures the return the business receives on the
stockholders’ equity invested in the business.
Measures the return after deducting preferred dividends
the business receives on the common stockholders’ equity
invested in the business.
Market ratios and earnings per share analysis, or shareholder ratios - they describe the firm’s financial condition in terms of
amounts per share of stock.
1.
Book Value Per
share
2.
Market/Book ratio
3.
Basic
Earnings
Per Share
Total Stockholders’ Equity – Preferred
Equity
Number of Common Shares
Outstanding
Market Price per Share
Book Value per Share
Income Available to Common
Stockholders (IAC)*
Weighted-Average Number of
Common Shares Outstanding
(WANCSO)
* Net Income
− Noncumulative preferred dividends
DECLARED (whether or not paid) and/or
− Cumulative preferred dividends EARNED
(whether or not declared)
4.
Diluted Earnings
Per Share
Represents the per share amount for the common
stockholders that would result if the company were to be
liquidated at the amounts that are reported on the
company’s balance sheet.
The ratio between the company’s market price per share and
its book value per share.

The earnings per share for all common shares that
were actually outstanding during the period.

Earnings per share (EPS) is the amount of income that
the holder of one share of common stock would have
received if 100% of the company’s profit had been “paid”
(distributed as dividends) to the holders of all the
common shares outstanding. Earnings belong to the
common shareholders whether distributed as
dividends or retained in the company to support future
growth, so earnings per share is an important measure
(We will not elaborate the computation of BEPS and
DEPS anymore because this is part of IA 3)
A variation of BEPS where IAC and WANCSO are adjusted to reflect the effect of potential common shares namely
Options & Warrants, Convertible Preferred Shares and Convertible Debt Instruments

5.
Price/Earnings
(P/E) ratio
Market Price per Common Share
Basic Earnings per Share (annual)
6.
Price/EBITDA
ratio
Market Price per Common Share
EBITDA per Share
Gives an indication of what shareholders are paying for
continuing earnings per share.

Investors view it as an indication of what the market
(public) considers to be the firm’s future earning
power.

It also sometimes known as the price multiple or the
earnings multiple.

The P/E ratio is greatly influenced by where a company
is in its cycle. A company in a growth stage will usually
have a high P/E ratio because of the market’s
expectations of future profits (which makes the market
price higher) despite the fact that at the current time,
profits may be low. Companies with low growth generally
have lower P/E ratios.
The ratio between the company’s market price per common
share and its EBITDA per share.
7.
Earnings Yield
Basic Earnings Per Share (annual)
Current Market Price Per Common
Share
8.
Dividend Yield
Annual Dividends Per Common Share
Current Market Price Per Share
9.
Dividend
ratio
Payout
10. Shareholder
Return
Annual Dividend Per Common Share
Basic Earnings Per Share
OR
Total Common Dividends (Annual)
Income Available to Common
Shareholders
Ending Stock Price
– Beginning Stock Price
+ Annual Dividends Per Share
Beginning Stock Price

Measures the income-producing power of one share of
common stock at the current market price.

It is the inverse of the P/E ratio.

Measures the relationship between the current annual
dividend and the current market price.

If the company keeps its dividend payout (pagbabayad
ng dividendo) low in order to retain profits in the
company for future growth, the dividend yield will be
low. If the company is able to invest the retained
earnings profitability, the price of the company’s stock
should rise, providing return to investors in the form of
capital gain (Tumaas ang value ng shares na hawak
mo) rather than in the form of dividends.

Measures the proportion of earnings paid out as
dividends to common stockholders.

Generally, a new company or a company that is
growing will have a low or no dividend payout,
because it is retaining earnings in the company to
finance its growth.
Measures the total return to individual shareholders on their
investments in the company’s common stock. (Dalawa ang
kitaan sa stocks – dividends and capital gains/share
appreciation)
Ano guys, ok pa kayo?haha
CONCEPTS ang mga ‘yan kasi na dapat inuunang intindihin at binabalikan. Pero hindi naman dapat lahat naunawaan mo.
Alam ko, kagaya niyo, may mga konsepto talaga diyan na mahirap unawain lalu na kung kulang o wala ka sa practice o sa
industry. Habang tinatahak niyo pa ang natitirang halus dalawang taon niyo sa College, unti-unti, mas lalong magkakalinaw
ang mga konseptong ito. Personally, mas lalu kong naintindihan ang deeper meaning ng ibang ratios diyan lalu na sa
Market Ratios nung nagsimula akong magkaroon ng interest sa Stock Investing/Trading. As investor kasi, dapat alam mo
yung mga factors affecting the market price of a certain stock.
Halimbawa, guys, si AMAZON. Kilala niyo naman siguro si AMAZON diba. Hindi na lang siya isang e-commerce company
ngayun. Nagmamanufacture narin sila ng electronic devices. May video streaming service (Amazon Prime) narin sila
katulad ni NETFLIX. May cloud-based products narin sila at marami pang iba.
Pansinin niyo ang mga sumusunod na key financial ratios niya sa kasalukuyan. Kayu nga humusga kung kumusta ang
financial health niya:
ROE = 18.58%
ROA= 5.97%
BVPS= $130.81/share
Profit Margin = 4.13%
Debt to Asset = 72.45%
EPS = $20.93/Share
Current market price, June 15, 2020 = $2,572.68/share
PE Ratio = 122.92
Asset Turnover = 1.48
Inventory Turnover = 9.97
Receivable Turnover = 17.86
Quick Ratio = 0.84
Current Ratio = 1.08
Haha… Diba wala kayung ma-draw na conclusion kung healthy ngaba siya. So paano mo malalaman kung maganda ang
financial health niya? KAILANGAN MO NG “BENCHMARSK” O “STANDARDS”. Paano makukuha mga yun, tatlong
paraan:
1. Industry averages – ito yung average ratios ng lahat ng companies that belong in the SAME INDUSTRY, say Retail
industry, banking industry, or real estate industry. So, if the industry ROE is 10% versus Amazon’s 18.58%, then we
can conclude that Amazon’s equity investors is earning more than that of its peers in the industry.
2. Trend comparison – a year to year or trend (say 5 years) analysis. If ROE in 2018 is 15% versus 18.58% in 2019, or
for 5 years (10%, 12%, 14%, 16%, and 18%), we can conclude that equity investors’ earnings growth is increasing,
hence a good sign of Amazon’s future profitability.
3. Management expectations – A target ROE of 15% set my management in 2019 versus an actual ROE of 18.57% is a
sign that Amazon is profitable and that management has been very efficient in managing the resources of the entity.
Yes, anu yang graph na ‘yan? This is a trail of AMAZON’s market price per share since May 1, 1997 to June 16, 2020 or
23 years after. From $1.50 per share on May 1, 1997 to $2,572.68 per share on June 15, 2020. So, that’s a whopping
171,412% increase for 23 years. So if you invested to AMAZON $1,000 on May 1, 1997 and hold it until now, you have
already accumulated $1,715,120, excluding dividends. No wonder, Jeff Bezos, 56 years old, the Founder and CEO of
Amazon, still holds the title as the Richest Man of the World. Currently, AMAZON has a market capitalization (total
outstanding shares x current market price) of 1.30 TRILLION DOLLARS or PhP65,000,000,000,000 (65 trillion pesos).
FYI…
APPLE has a market cap of $1.52 TRILLION (Currently, the most valuable US publicly listed Company),
MICROSOFT is $1.47 TRILLION,
GOOGLE is $486 BILLION,
TESLA is $184 BILLION,
FACEBOOK is $673 BILLION,
SM Investments Corporation is $22.6 BILLION (Phils’ most valuable Company),
AYALA CORPORATION is $9.72 BILLION,
ABS CBN is $266 MILLION,
GMA is $346 MILLION, and
DITO is $153 MILLION.
What I want you to realize is, a company’s financial ratios will ultimately be reflected in the company’s stock price.
If Amazon’s financial ratios have been favorable for the last 23 years, it could have been the very reason why
investors are piling up their money to Amazon, hence causing the stock price to surge, hence creating more value
or wealth for shareholders/investors.
As business students, you should realize that this is an opportunity (huge return) coupled with risks (losing
money). Necessarily, if you realized that there is indeed opportunity, manage the risk. How will you manage risk?
There are many ways – one of them is FINANCIAL RATIO ANALYSIS.
So, after this course, I expect that you will develop an inclination of investing in the stock market because there is
really huge opportunity. While you are still young, the time to accumulate your wealth is huge. So study unlimitedly
and diligently. Set priorities. Monitor your expenses. Save regularly and invest wisely.
O ayan andami ko na naming sinabi. Pero totoo yan, guys! This is one of my greatest regrets in. Learn from our
mistakes and experiences – it is the cheapest way to learn. You don’t need to experience it.
Ok, let’s go back to our main course. In order for you to appreciate more the concepts, I will now present to you
the illustrative case for Financial Ratio Analysis. This illustration is taken from a CMA reviewer. This is a
comprehensive illustration, so be patience este patient. Let’s go!
Below are Balance Sheet, Income Statement, Statement of Cash Flows, and selected Notes to the Financial
Statements.
Required: Compute the financial ratios and evaluate the company.
SOLUTION:
The most important part – ANALYSIS AND INTERPRETATION
Liquidity
This company appears to have a very strong liquidity position. The current ratio has consistently been over 6:1. This
is three times the norm of 2:1. On the other hand, the current ratio needs to be evaluated in light of the length of the
company’s operating cycle. So let’s look at the company’s operating cycle. That information is in the Activity Ratios. The
operating cycle is
Operating Cycle = Days Sales in Receivables + Days Sales in Inventory
For the most current year, the company had 77.6 days of sales in receivables and 51.34 days of sales in inventory, for
an operating cycle of 129 days according to the formula. This appears to be a long operating cycle, and the previous
year’s operating cycle was similarly long. The high level of accounts receivable that results from having over 77 days of
sales in receivables could be the reason for the high current ratio.
But is accounts receivable really that high? Let’s look at that more closely. On the balance sheet, we see that gross
accounts receivable equaled $724,000 at the end of Year 1. Gross receivables increased to $3,700,000 at the end of
Year 2, and then they dropped back to $722,000 at the end of Year 3. An increase followed by a decrease like this could
be caused by a number of things, but one thing we know for sure: since the number of days in receivables is calculated
using average accounts receivable, and since we calculate the average accounts receivable by averaging the beginning
and ending balances, the average accounts receivable balances we were using for both Year 2 and Year 3 were distorted
by the large increase in Year 2. The averages used may not be representative of the company’s average accounts
receivable. The company may have made a big sale just before the end of Year 2 that caused its accounts receivable as
of December 31, Year 2 to increase temporarily but was collected in a timely manner (a good thing). Or, the company
may have made a big sale earlier in the year that ultimately turned out to be uncollectible (a bad thing) and was
subsequently written off. The situation warrants further inquiry and investigation.
This question about the treatment of Year 2’s high receivable balance illustrates a rule in financial statement analysis:
we do not just calculate ratios blindly and draw conclusions from them without looking deeper. Sometimes further
investigation is needed to find the story behind the numbers.
In this case, our investigation has revealed that the increase in receivables at the end of Year 2 was due to a large sale
that was made just prior to yearend for which payment was received during the first month of the following year. The
collection period for other trade accounts receivable was 30 days at the end of Year 2. That is important information,
because it means that overall, the company is collecting its receivables in about 30 days time, not 77 days time, which
is favorable.
Furthermore, since the current ratio is calculated using year-end balances only, the Year 3 current ratio was not distorted
by the large increase in accounts receivable at the end of Year 2. This company’s liquidity position is truly as strong
as it appears to be.
Financial Leverage
This company has a little less than twice as much in total assets as it has in common equity, which means that a little
less than half of the company’s financing comes from debt. This is an acceptable level of debt: not too high and not too
low.
Interest expense has remained the same during the three years because the only long-term debt incurring interest is a
bond issue that has been unchanged. The bond was originally sold at par, so there was no discount or premium to be
amortized. Because the level of interest expense has remained unchanged, any increases or decreases in EBIT flow
straight to EBT. However, the effect of increases and decreases in EBIT is magnified because of the existence of the
interest expense. For this company, EBIT decreased in Year 3 because revenue decreased.
The magnification of increases/decreases in EBIT is measured by the Degree of Financial Leverage (DFL). Because the
DFL is greater than 1, EBT will increase (decrease) more, proportionally, than EBIT increases (decreases) To illustrate:
In Year 3, EBIT fell from $5,319,000 to $3,233,000, a 39% drop. EBT, however, fell by a greater percentage − 42% −
from $4,919,000 to $2,833,000.
Capital Structure and Solvency
This company’s capital structure and solvency ratios generally confirm its financial leverage ratios. The company’s
capital structure is a little less than half debt and a little more than half equity, an acceptable balance.
Earnings Coverage
The Interest Coverage (or Times Interest Earned) ratio decreased significantly in Year 3, to 8.08 from 13.30 in Year 2.
This decrease is due to the fact that EBIT decreased significantly in Year 3. In a weaker company, this might be a cause
for concern. However, this company still has more than enough earnings to cover its interest expense (8 times as much).
If this trend continues, however, this ratio could deteriorate and interest coverage could become a problem.
The Fixed Charge Coverage (Earnings to Fixed Charges) ratio also decreased sharply in Year 3 for the same reason.
Activity
We have already reviewed the situation with accounts receivable, so that will not be repeated. The number of days of
sales in inventory is fairly stable, at slightly more than 50 days. The number of days of purchases in accounts payable
has increased from 26.07 days in Year 2 to 33.46 days in Year 3. The company is generally current with its suppliers,
though if the upward trend in the number of days of purchases in payables continues, it could become a cause for
concern.
The fixed Asset Turnover ratio went down in Year 3, a reflection of the decreased revenue the company experienced in
Year 3.
Profitability
Revenue decreased significantly in Year 3 compared to revenue in Year 2. The economy went into a recession in Year 3,
and that probably accounts for the decreased sales. At 69%, the Gross Profit Margin Percentage has been very stable
throughout the three years analyzed, though gross profit in dollars dropped in Year 3 as compared to Year 2 because of
the decreased revenues. Since the Gross Profit Margin Percentage has held up well, a good working theory is that the
decrease in revenues was almost entirely due to decreased volume of sales and at most only minimally due to any price
concessions the company may have made because of the recession. Any price concessions made would have impacted
revenue and the gross profit margin negatively. However, profitability of the sales that were made was maintained.
The Operating Profit Margin and the Net Profit Margin have been steadily decreasing, however. The primary reason for
this has been management’s decision to increase its spending on research and development activities. R&D in Year 1
was $1,200,000, increasing to $1,800,000 in Year 2 and $3,000,000 in Year 3. R&D increases generally predict future
increased profits, and so this is probably a good sign. It is interesting that the company increased its R&D spending even
when revenues dropped in Year 3. That could be an indication of management’s commitment to the future. However,
the increased R&D expense could also result from failed R&D efforts. How successful the company’s R&D efforts have
been is a question that needs to be answered. In this case, there is no indication that the company’s R&D efforts have
been anything but successful.
Return on Invested Capital
ROA, ROE and ROCE all decreased significantly from Year 2 to Year 3, again because of the Year 3 decrease in earnings
caused by decreased revenues coupled with increased R&D expense.
Market Ratios
The market punished this stock severely in Year 3 because of its sales and net income decreases, with the stock price
falling from $31 per share at the end of Year 2 to $13 per share at the end of Year 3. That fact has affected the company’s
Year 3 market ratios significantly.
The Market/Book ratio should be at least 1.0. The Market/Book ratio decreased in Year 3 to 1.43 from 3.85 the previous
year. It is getting close to the 1.0 mark because of the large decrease in the market price of the company’s stock.
The Price/Earnings Ratio is used rather extensively by investors to determine whether a publicly-traded stock is a good
investment. Comparing a company’s P/E ratio with that of a benchmark such as the S & P 500 index can give an investor
an idea of whether the stock is underpriced, overpriced, or fairly priced. As this is being written, the average P/E ratio
of S & P 500 stocks is 19.30. This company’s P/E ratios for Years 1, 2 and 3, respectively, have been 15.17, 14.03, and
10.32. Thus, this company’s stock has been somewhat underpriced compared with stocks in the S & P 500. Furthermore,
the company’s P/E ratio has been declining, indicating its stock price has fallen relatively more than the decrease in its
earnings per share. The low P/E ratio could indicate that the stock is a good value, a positive indicator. Value investors
look for underpriced stocks in the belief that other investors will eventually realize that the stock is underpriced and the
price will increase.
However, a low P/E ratio could also indicate that investors do not consider the company’s future earnings prospects to
be very favorable, which is a negative indicator.
The Dividend Yield has increased each year, from 1.63% in Year 1 to 2.31% in Year 3. However, common Dividends per
Share were cut in half in Year 3 (from $0.60 per share to $0.30 per share) due to the company’s decreased earnings.
The increased Dividend Yield Ratio in Year 3 despite the dividend cut is due to the large drop in the market price of the
stock.
The Dividend Payout Ratio has been between 23% and 27% for the past three years, a healthy level. If a company pays
out too much of its earnings in dividends, the company is weakened financially because it does not have adequate
retained earnings. The dividend payout ratio should be generous, but if it is too generous, that indicates that dividends
will probably be cut in the future, which in turn will probably cause a drop in the stock’s market price.
Other
The Sustainable Growth Rate has decreased from 22.40% in Year 2 to 11.26% in Year 3. The decrease was due to the
decreased earnings in Year 3. The company has chosen to maintain its dividend payout ratio (though not the dividend
level) in the face of depressed earnings. Considerably fewer earnings were retained by the company in Year 3 compared
to Year 2. Furthermore, the return earned on those retained earnings was lower in Year 3.
Cash Flow
The statements of cash flows reveal that this company generates quite a bit of cash from its operating activities. In Year
3, net cash provided by operating activities was $4,609,000, and that amount would have been even higher if net
purchases of trading securities had not been $2,500,000, an activity the company classifies as an operating activity.
A great deal of Year 3’s operating cash inflow was generated by the collection of accounts receivable. Accounts receivable
decreased from the end of Year 2 to the end of Year 3 by $2,975,000. The unusually large collection was caused by the
large receivable that was generated at the end of Year 2 and was collected early in Year 3. However, operating cash
flows are typically high, even without the large receivable, as Year 2’s net operating cash flow was over $3,000,000.
In Year 3, the company used $2,709,000 of the operating cash flow it generated for investing activities, primarily for the
purchase of available-for-sale securities. In addition, the company used $505,000 in financing activities for paying
dividends. Proceeds from the issuance of stock in Year 3 were $225,000, for a net cash used by financing activities of
$280,000.
Summary
This is a strong company that is well positioned to not only survive but also to thrive during a temporary downturn in
its revenues and earnings caused by a recession in the economy. As long as the economic downturn does not continue
too long, the company should come out of the recession stronger than ever and with an improved product offering due
to its recent increased R & D activities. However, if the economic downturn continues for an extended period of time,
the company’s financial situation will certainly deteriorate.
Limitations of Ratio Analysis
Although ratio analysis provides useful information pertaining to the efficiency of operations and the stability of financial
condition, it has inherent limitations.

A ratio by itself is not significant. It must be interpreted in comparison with prior periods’ ratios,
predetermined benchmarks, or ratios of competitors.

The ability to make use of ratios is dependent upon the analyst’s ability to adjust the reported numbers before
calculating the ratios and then to interpret the results.

Financial statement analysis cannot give definite answers. It can point out where further investigation is
warranted; but it is a mistake to place too much importance on a simple analysis of financial statement numbers.

Accounting and the preparation of financial statements require judgment in making assumptions and
estimates. The more frequent the publication of financial statements, the more frequent will be the need to
make these estimates, and the greater will be the uncertainty inherent in the financial statements and thus the
ratios calculated from them, because many transactions require several quarters or several years for completion.
The longer the time it takes to complete a transaction, the more tentative will be the estimates relating to it that
affect the financial statements. The short-term incentives, agendas, and personal interests of those who prepare
them may affect these estimates relating to long-term events.

Ratios’ usefulness depends on the quality of the numbers used in their calculation. If a company’s
financial statements are not credible because of poor internal controls or fraudulent finan-cial reporting, then
the resulting ratios will be just as unreliable and misleading as the financial statements. However, a critical
analysis of ratios can alert an analyst to the possibility of problems in the financial reporting, because he or she
may see that the ratios do not make sense.


The numbers constitute only one part of the information that should be considered when evaluating a company.
Qualitative aspects such as employee morale, new products under development, the company’s reputation,
customer loyalty, or the company’s approach to its social responsibilities are also important.
When we compare a company with other companies, the various companies’ financial statements will
probably classify items differently. To the extent possible, we should make adjustments in order to make
the statements as comparable as possible. However, making these adjustments may not always be possible,
and that can make it difficult to draw conclusions from the comparisons.

Many companies are conglomerates and are made up of many different divisions operating in different,
unrelated industries. This diversification20 can make it difficult to compare any two companies, because while
they may share some markets, they seldom share all of the same markets.

Companies can choose different methods of computing things such as depreciation expense, cost of goods
sold, and bad debt expense. Leases can be reported as operating leases, appearing only in the income statement,
or they can be capitalized and reported on the balance sheet. These variations in reporting also affect the
comparability of companies.

A company may have poor operating results that are caused by several different, small factors. If an analyst
focuses on trying to find one major problem, he or she may miss the confluence of many factors.

Traditional ratio analysis focuses on the balance sheet and income statement, and therefore cash flow ratios
may be overlooked. 


The goal of financial analysis is to make predictions about how a company will do in the future. In contrast, ratio
analysis is performed on historical data and may have little to do with what is going on currently at the
company. Current data such as news releases from the company must be included in the analysis, as well as
historical information.

Many financial statement items are based on historical cost values. Ratios based on those historical cost
values may be less relevant to a decision than current market values.

To be meaningful, a ratio must measure a relationship that is meaningful. For example, the relationship
between sales and accounts receivable is meaningful, so the ratios that relate those items are significant.
However, there is no meaningful relationship between the average balance of total long-term debt and freight
costs, so a ratio relating those items to one another would be useless.

Financial statements consist of summaries and simplifications for the purpose of classifying the economic
events and presenting the information in a form that can be utilized. In some cases, the details behind the
summarized transactions are recoverable, but in other cases they are not.

Financial statements deal only with monetary amounts and do not reflect the decrease in the purchasing
power of money that occurs with inflation. Therefore, comparing values over a long period-od of time may be
misleading.
Congratulations for reaching this part! 
That ends Financial Statements Analysis. You may take a long rest muna.
If you are ready, you may now take the Exercises for Financial Ratio Analysis!
Supplemental Readings:
 https://courses.lumenlearning.com/boundless-finance/chapter/asset-management-ratios/
 https://www.accountingverse.com/managerial-accounting/fs-analysis/financial-ratios.html
 https://www.thebalancesmb.com/how-do-you-do-financial-statement-analysis-393235
 https://www.principlesofaccounting.com/chapter-16/statement-analysis/
 https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4-waysassess-business.aspx