Ratio Analysis PDF

## Business Finance ### Chapter 2: Review of Financial Statement Preparation, Analysis, and Interpretation **Analyzing the operations of a company, it is important to look at the percentage increases in accounts receivable, inventories, and accounts payable. If the percentage increases in accounts...

## Business Finance ### Chapter 2: Review of Financial Statement Preparation, Analysis, and Interpretation **Analyzing the operations of a company, it is important to look at the percentage increases in accounts receivable, inventories, and accounts payable. If the percentage increases in accounts receivable, inventories are higher than the increase in sales, then an investigation of the sources of difference has to be made. This situation is an indication of inefficient management of accounts receivable and inventories. ** **In the case of ADP Foods Company, the increases in accounts receivable were higher in 2019 and 2017 as compared to the increases in net sales which can indicate less efficient management of accounts receivable. The percentage increases in inventories were much higher in 2018 and 2017 as compared to percentage increases in net sales indicating more inefficient handling of inventories for these years. ** **While a higher increase in trade accounts payable relative to sales may be welcome, the sources of the difference still need to be assessed. If the increase in accounts payable is due to better credit terms provided by suppliers, then this is a positive development. However, if the increase is due to delays in payment to suppliers, then this is a sign of improper management of the account and may result in adverse consequences in the future, e.g. suppliers may not deliver on time or may charge higher prices for their deliveries.** ### Financial Ratios **In this section, the following financial ratios will be discussed:** 1. **Profitability Ratios**: These ratios measure the returns on investors and the operating performance of a company during a given accounting period. The following ratios are used to measure the profitability of a company: * **Return on equity (ROE)** * **Return on assets (ROA)** * **Gross profit margin** * **Operating profit margin** * **Net profit margin** 2. **Efficiency Ratios**: Efficiency ratios, otherwise known as turnover ratios and activity ratios, are called as such because they measure the management's efficiency in utilizing the assets of the company. The following efficiency ratios will be discussed in this section: * **Total asset turnover ratio** * **Fixed asset turnover ratio** * **Accounts receivable turnover ratio** * **Inventory turnover ratio** * **Accounts payable turnover ratio** * **Operating cycle and cash conversion cycle. These are not financial ratios but are very useful in evaluating the company's efficiency in managing working capital accounts. From the accounts receivable turnover ratio, inventory turnover ratio and accounts payable turnover ratio, these two cycles can be computed.** 3. **Liquidity Ratios**: These ratios measure the ability of a company to pay maturing obligations from its current assets. Two commonly used liquidity ratios will be discussed in this section. * **Current ratio** * **Acid-test ratio or sometimes called quick asset ratio** 4. **Stability or Leverage Ratios**: There are so many names associated with stability ratios. These are leverage ratios, solvency ratios, and debt ratios. In practice, they are used interchangeably. Stability ratios show the capital structure of a company, i.e., how much of the total assets of a company are financed by debt and how much is financed by equity. They can also be used to measure a company's ability to meet long-term obligations. In this section, the following stability ratios will be discussed: * **Debt ratio** ​* **Debt-equity ratio** ​* **Interest coverage ratio** ### Profitability Ratios Profitability ratios measure the returns to investors and the performance of a company during a given accounting period. * **Return on equity (ROE)** > Return on equity (ROE) is a profitability measure that should be of interest to the owners of the company, whether they are single proprietors, partners, or shareholders. If a company is publicly listed, this should be of interest also to the potential stock market investors. ROE measures the amount of net income earned in relation to equity. It is computed as follows: * **ROE = Net income + Equity** > In computing ROE, different approaches are observed. There are analysts who use the average of the equity for two accounting periods, while others simply use the year-end balances. Whichever formula is used, consistency must be observed. > To illustrate, let us use the financial statements of ADP Foods Company in 2019 (refer to Exhibit 2.1 for net income and Exhibit 2.2 for Alfonso's capital or equity). * **ROE = (Net income + Equity) x 100%** * **ROE = (2,659,087 + 12,478,559) x 100%** * **ROE = 21.31%** > The ROE of 21.31% means that for every P1.00 of owner's equity, P0.2131 or 21.31 centavos was earned in 2019. To be more meaningful, this rate of return is compared with the returns on alternative investments such as the returns on time deposits and other income instruments. For example, if the interest on time deposits is only 2%, then the 21.31% ROE seems better. However, before a conclusion is made that the 21.31% ROE is better than the time deposit rate of 2%, the risks associated with this company earning 21.31% have to be assessed. Unless a bank will experience a bank run, the 2% time deposit rate is guaranteed while the 21.31% ROE is not. > In 2019, the ROE of ADP Foods Company was high. But what if previously, it earned negative ROE. Is this possible for a company? No manager of any company who is in his/her sound mind will guarantee a specific rate of return, especially when that rate is relatively high. Why? Because in business, there are always risks. A company that is doing so well this year may find itself with too many competitors in the future and these competitors may eat their share of the business in the market and can make a profitable company today a losing company in the future. For example, a publicly listed Philippine company had an ROE of 48% in 2005. Its ROE went down to 12% in 2017. It is interesting to know that way back in 2000, its ROE was -2%. * **Return on assets (ROA)** > Return on assets (ROA) measures the ability of a company to generate income out of its resources. Below is the formula for computing ROA: * **ROA = (Operating income + Total assets) x 100%** > Like ROE computations, ending balance or the average balance of total assets for two years can be used, but consistency in the application of formulas must be observed. > This ROA ratio is useful in making decisions. For example, if a company has an opportunity to expand and is not sure how to finance the expansion, the ROA can be used in making a decision. If the borrowing rate is greater than ROA, then it does not make sense to borrow for expansion. However, if the expected ROA with the expansion is greater than the cost of borrowed funds, then management may consider debt financing to fund expansion. It must be noted at this point that this comparison of borrowing cost and ROA is not the only factor considered in expansion. There are other factors that will be considered in subsequent chapters. > To illustrate, compute ADP's ROA for 2019 (refer to Exhibit 2.1 for operating income and Exhibit 2.2 for the total assets). * **ROA = (4,048,696 + 22,298,020) x 100%** * **ROA = 18.16%** > The 18.16% ROA means that in 2019, ADP Foods Company generated 18.16 centavos operating income for every P1.00 of an asset in the company. * **Gross profit margin** > The formula for computing gross profit margin is shown below: * **Gross profit margin = (Gross profit + Net sales) x 100%** > Gross profit margin provides information regarding the ability of a company to cover its cost of goods sold from its sales. To illustrate, compute the gross profit margin of ADP Foods Company in 2019 (refer to Exhibit 2.1 for the gross profit and net sales). * **Gross profit margin = (10,546,355 + 52,501,085) x 100%** * **Gross profit margin = 20.09%** > This ratio means that for every P1.00 of sales the company generates, it earns 20.09 centavos in gross profit. Companies in a very competitive industry have to watch out for this gross profit margin because stiff competition can substantially bring down this margin. > If the manager of the company wants to improve its gross profit margin, two things can be done: 1. *Raise prices of products.* 2. *Find ways to bring down production costs. For trading or merchandising companies, find a supplier which can sell finished goods to the company at low prices.* > Both approaches are not easy to do. Raising prices is possible if the company is the only seller or provider of this product or service in the area. If there are many sellers, however, raising prices can make the products appear expensive and buyers may go to companies who offer their products at cheaper prices. As the saying goes, if a company sets the prices of its products too high, it may be pricing itself out of the market. > The second approach which is to bring down production costs may not also be easy to achieve because this may require investment in technology. It may also require identifying cheaper sources of raw materials. Trying to make the production more efficient can also help. For example, similar products have to be produced in batches to save on manufacturing overhead costs. * **Operating profit margin** > Operating profit margin measures the amount of income generated from the core business of a company. Operating profit is computed as the difference between gross profit and operating expenses (refer to Exhibit 2.1). The formula for computing the operating profit margin ratio is shown below: * **Operating profit margin = (Operating income + Net sales) x 100%** > In the case of the given illustrative example, ADP Foods Company, an analyst would be interested to find out how much operating income does this company generates from its food business. Below is the computation of ADP's operating profit margin (refer to Exhibit 2.1 for operating income and net sales). * **Operating profit margin = (4,048,696 + 52,501,085) x 100%** * **Operating profit margin = 7.71%** > The 7.71% operating profit margin means that out of 1.00 net sales that ADP Foods Company generated in 2019, the company earned 7.71 centavos after deducting the cost of sales and operating expenses. This amount is before the effects of income taxes. * **Net Profit Margin** > Net profit margin measures how much net profit a company generates for every peso of net sales or revenues that it generates. The formula for computing net profit margin is shown below: * **Net profit margin = (Net income + Net sales) x 100%** > Net income is the amount left after all expenses have been deducted from net sales, including interest expense and income taxes. > To illustrate, compute the net profit margin of ADP Foods Company in 2019 (refer to Exhibit 2.1 for net income and net sales). * **Net profit margin = (2,659,087 + 52,501,085) x 100%** * **Net profit margin = 5.06%** > In 2019, ADP Foods Company earned 5.06 centavos for every 1.00 of net sales generated. > An analyst of the statement of profit or loss should compare the operating profit margin and the net profit margin. A company can have a high operating profit margin but may end up with a low or even a negative net profit margin if the company is heavily indebted. This situation was observed with many local cement companies after the 1997 Asian financial crisis where cement companies reported positive operating profit margins but reported negative net profit margins. This situation indicates that the core business is good but the financing may not be appropriate because the cement companies relied too much on borrowing to finance their expansions before the 1997 Asian financial crisis. > It is also important to note if the net profit used in computing the ratio is substantially due to core operations or the main business of the company, or due to some nonrecurring transactions. An example of a nonrecurring transaction is gain from the sale of equipment where the company is not in the business of selling equipment. ### Efficiency Ratios or Turnover Ratios These efficiency ratios, which are also known as activity ratios, measure a company's efficiency in the utilization of its assets. These ratios are very critical in understanding the operations of a company, especially in the management of working capital accounts which include accounts receivable and inventories. From the accounts receivable turnover ratio, inventory turnover ratio and accounts payable turnover ratio, the operating cycle and cash conversion cycle can be computed. * **Total asset turnover ratio** > The total asset turnover ratio measures the company's ability to generate revenues for every peso of asset invested. It is an indicator of how productive the company is in utilizing its resources. The formula is shown below. * **Total asset turnover ratio = Net sales + Total assets** > Compute the asset turnover ratio of ADP Foods Company in 2019 (refer to Exhibit 2.1 for net sales and Exhibit 2.2 for total assets). * **Total asset turnover ratio = 52,501,085 + 22,298,020** * **Total asset turnover ratio = 2.35** > The total asset turnover ratio of 2.35 means that for every 1.00 of asset ADP Foods Company has in 2019, it is able to generate net sales of P2.35. > In computing the total asset turnover ratio, ending balances for total assets or the average of total assets for the accounting period can be used. Whichever formula is used, consistency must be applied. * **Fixed asset turnover ratio** > If a company is heavily invested in property, plant, and equipment (PPE) or fixed assets, it pays to know how efficient the management is with the utilization of these assets. This can be applied to companies that are characterized by high PPE such as utility companies, e.g., telecom companies, power generation and distribution companies, and water distribution companies. It can also be applied to manufacturing companies. The formula for computing fixed asset turnover ratio is shown below: * **Fixed asset turnover ratio = Net sales PPE** > Let us compute the fixed asset turnover for ADP Foods Company in 2019 (refer to Exhibit 2.1 for the net sales and Exhibit 2.2 for the PPE). * **Fixed asset turnover ratio = 52,501,085 + 12,200,000** * **Fixed asset turnover ratio = 4.30** > In 2019, ADP Foods Company was able to generate P4.30 net sales for every 1.00 of PPE that it has. > The ending balance of PPE or the average PPE balances for two consecutive accounting periods can be used. Consistency, however, must be applied in the application of the formula. * **Accounts receivable turnover ratio** > The accounts receivable turnover ratio measures the efficiency by which accounts receivable are managed. A high accounts receivable turnover ratio means efficient management of receivables. The formula for accounts receivable turnover ratio is shown below: * **Accounts receivable turnover ratio = Net sales + Gross trade accounts receivable** > If there are different types of receivables, consider only the trade accounts receivable. These are the accounts receivable created in the ordinary course of business. Also, if there is an allowance for doubtful accounts, use the gross amount of trade accounts receivable. This amount is generally found in the notes to financial statements where more information about accounts receivable is disclosed. > Some analysts use average gross trade accounts receivable, instead of the ending accounts receivable. Whichever approach is used, consistency must be observed. > Compute the accounts receivable turnover ratio for ADP Foods Company in 2019 (refer to Exhibit 2.1 for net sales and Exhibit 2.2 for gross trade accounts receivable). * **Accounts receivable turnover ratio = 52,501,085 + 2,300,000** * **Accounts receivable turnover ratio = 22.82** > The accounts receivable turnover ratio becomes more meaningful when converted into days' receivable or average collection period. In the illustrative example, this 22.82 accounts receivable turnover ratio can be converted into days by dividing 360 days (if information is based on annual data and use 90 days if based on quarterly data) by the accounts receivable turnover ratio. > *In this exercise, the gross trade accounts receivable of 2,300 is assumed to be the same as its net realizable value. Otherwise, if there are allowances for doubtful accounts, use the gross trade receivable which is found in the notes to financial statements.* * **Average collection period = 360 + 22.82** * **Average collection period = 15.77 or 16 days** > In 2019, ADP Foods Company had an average of 16 days collecting its accounts receivable. This means that from the day the sale was made, it took the company 16 days, on the average, to collect its trade accounts receivable. * **Inventory turnover ratio** > Inventory turnover ratio measures a company's efficiency in managing its inventories. Trading and manufacturing companies, companies that are dealing with highly perishable products, and those that are prone to technological obsolescence must pay close attention to this ratio to minimize losses. The formula for computing inventory turnover ratio is shown below: * **Inventory turnover ratio = Cost of sales + Inventories** > Like the computation of accounts receivable turnover ratio, either ending balance or the average inventories can be used. Whichever formula is used, consistency must be observed. > For manufacturing companies that may have three types of inventories - finished goods, work in process, and raw materials inventories - all must be included in the computation. This is to measure a company's level of efficiency in managing this account. > Compute the inventory turnover ratio of ADP Foods Company in 2019 (refer to Exhibit 2.1 for the cost of sales and Exhibit 2.2 for inventories). * **Inventory turnover ratio = 41,954,730 ÷ 4,849,304** * **Inventory turnover ratio = 8.65** > The inventory turnover ratio becomes more meaningful when converted into days' inventories. To convert, simply divide 360 days by the inventory turnover ratio if annual data are used. Otherwise, use 90 days if quarterly data are used. * **Days' inventories = 360 + Inventory turnover ratio** * **Days' inventories = 360 ÷ 8.65** * **Days' inventories = 41.62 or 42 days** > These 42 days' inventories means that in 2019, ADP Foods Company took 42 days, on average, to sell its inventories from the time they were bought. * **Accounts Payable Turnover Ratio** > The accounts payable turnover ratio provides information regarding the rate by which trade payables are paid. Any operating company will prefer to have a longer payment period for its accounts payable, but this should be done only with the concurrence of the suppliers. The formula below shows the computation for the accounts payable turnover ratio: * **Accounts payable turnover ratio = Cost of sales + Trade accounts payable** > computed as follows (refer to Exhibit 2.1 for the cost of sales and Exhibit 2.2 for the trade accounts payable): * **Accounts payable turnover ratio = 41,954,730 ÷ 5,050,810** * **Accounts payable turnover ratio = 8.31** > Ideally, purchases should have been the numerator in the formula, but this amount is not readily available in the statement of profit or loss. A close substitute for purchases is the cost of sales, or sometimes called the cost of goods sold. Purchases are definitely a function of sales and the cost of sales is a function of sales. Given this line of reasoning, the cost of sales can be a very good substitute for purchases. > Ending balance or average trade payables can be used in the computation, but observe consistency on the application of the formula. > From the accounts payable turnover ratio, days' payable can be computed. For ADP Foods Company, days' payable in 2019 was 43.32 days or 43 days computed as follows: * **Days' payable = 360 + Accounts payable turnover ratio** * **Days' payable = 43.32 or 43 days** > This number suggests that in 2019, the average payment period of the company for its trade accounts payable was 43 days. * **Operating Cycle and Cash Conversion Cycle** > By adding the average collection period and days' inventories, the operating cycle can be computed. This operating cycle covers the period from the time the merchandise is bought to the time the proceeds from the sale are collected. Managers of companies will prefer to have a short operating cycle as compared to a long one. A low or short operating cycle is an indication of efficient management of trade accounts receivable and inventories. > In 2019, ADP Foods Company had an operating cycle of 58 days computed as follows: * **Operating cycle = Days' inventories + Days' receivable** * **Operating cycle = 42 + 16** * **Operating cycle = 58 days** > When ADP Foods Company bought the merchandise, did it already pay for the merchandise bought? Chances are the company was given credit terms. As the days' payable suggests, payment to suppliers averaged 43 days in 2019. If one is interested to find out how long it takes the company to collect receivables from the time the cost of the merchandise sold was actually paid, a cash conversion cycle, or sometimes called the net trade cycle, can be computed. The formula is shown below: * **Cash conversion cycle = Operating cycle - Days' payable** > For ADP Foods Company, its cash conversion cycle is 15 days computed as follows: * **Cash conversion cycle = 58 days - 43 days** * **Cash conversion cycle = 15 days** > The cash conversion cycle is inversely related to the operating cash flows. If the cash conversion cycle is low, expect more operating cash flows and the reverse is true. > As will be discussed in the section on liquidity ratios, attention must be given to the quality of accounts receivable and inventories which can be measured by their turnover ratios. So, in analyzing the liquidity position of a company, it is not enough to look at the current ratio and the quick asset ratio, check the average collection period or days receivable and days inventories as well. It may be good to also check the operating cash flows. > These turnover ratios can vary from one industry to another and can also vary from one company to another even if they come from the same industry. Industry peculiarities and the style of management may influence these turnover ratios. > Note that in the computation of total asset turnover ratio, accounts receivable turnover ratio, inventory turnover ratio, and accounts payable turnover ratio, some references use average balances in the denominators. Whichever formula is used, consistency in the application of the formulas must be observed. ### Liquidity Ratios Liquidity ratios measure the ability of a company to pay maturing obligations, either to suppliers, creditors or other vendors. * **Current ratio** > The formula for computing the current ratio is shown below: * **Current ratio = Current assets + Current liabilities** > Current assets include cash and other assets which are expected to be converted into cash within 12 months such as accounts receivable and inventories. Current assets also include prepayments such as prepaid rent and prepaid insurance. > Current liabilities include obligations that are expected to be settled or paid within 12 months. These include accounts payable, accrued expenses payable such as accrued salaries, and the current portion of long-term debt. The current portion of long-term debt is the principal amount of a long-term loan expected to be paid within the next 12 months from the balance sheet date. > To illustrate, compute the current ratio of ADP Foods Company in 2019 (refer to Exhibit 2.2 for current assets and current liabilities). * **Current ratio = Current assets ÷ Current liabilities** * **Current ratio = 9,262,331 ÷ 7,819,461** * **Current ratio = 1.18** > The current ratio of 1.18 means that for every 1.00 of current liabilities that ADP Foods Company has, it has P1.18 current assets as of December 31, 2019. > A high current ratio provides comfort that a company will be able to pay obligations on time, but a high current ratio does not guaranty that no liquidity problems or cash flow problems will arise. The ability of a company to pay on time also depends on the quality of receivables and inventories. For example, a company with a current ratio of 2.5 may end up having difficulty paying on time. Why? Maybe because its accounts receivable takes 90 days, on average, to be collected. Or its inventories take months to be sold. > In evaluating liquidity ratios such as the current ratio, attention must also be made to the quality of other current assets which were discussed in the turnover or efficiency ratios. * **Acid-test ratio or quick asset ratio** > Below is the formula for quick asset ratio: * **Quick asset ratio = (Cash + Current accounts receivable + Short-term marketable securities) ÷ Current liabilities** > The quick asset ratio is a stricter measure of a company's liquidity position. There are some textbooks that compute quick assets as current assets fewer inventories. With this definition, the quick asset ratio can also be computed as follows: * **Quick asset ratio = (Current assets - Inventories) ÷ Current liabilities** > Note that the first formula is a stricter measure of the acid-test ratio. > Common to both the current ratio and the quick asset ratio is the accounts receivable. The real test of a company's ability to meet its maturing obligations largely depends on the quality of its receivables. Even if a company has a high quick asset ratio, a company is not assured that no liquidity problems will arise if the collection of accounts receivable takes too long. > To illustrate, compute the quick asset ratio of ADP Foods Company in 2019 (refer to Exhibit 2.2 for determining the quick assets and current liabilities). * **Quick asset ratio = (1,062,527 + 2,300,500) ÷ 7,819,461** * **Quick asset ratio = 0.43** > This ratio means that for every 1.00 current liability the company has, it has 43 centavos in quick assets. Is this something to be alarmed about? The answer depends on the quality of accounts receivable which can be determined by its collection period. A low or short collection period is preferred. ### Stability or Leverage Ratios Stability ratios measure how much of the total assets of a company are financed by liabilities and equity, otherwise known as capital structure. Before discussing the different stability ratios, it is important to identify the factors that affect the capital structure of a company. 1. **Nature of business.** If a company is in a risky business and operating cash flows are uncertain like mining operations, it has to be more conservatively financed. Conservative financing means there should be more equity. If the business is characterized by stable operating cash flows like what is true for big retail and mall operators in the country where cash flows from rent are almost certain, then a more aggressive capital structure can be considered. Stable operating cash flows allow the company to pay periodic debt amortizations. 2. **Stage of business development.** A company that is just starting its operations may encounter difficulties borrowing from banks. Banks generally look for the historical performance of a company in making decisions regarding loan applications. A new company does not have that historical record. > From the shareholders' or owner's point of view, it is not also good to start an operation with borrowed funds. What if the business fails? When a company has already established its foothold in its market and there are opportunities to expand, then that may be a good opportunity to partially use borrowed funds to finance an expansion. > By this time, management should have been more familiar with the business and can anticipate possible problems. 3. **Macroeconomic conditions.** If macroeconomic conditions are good as measured by gross domestic product (GDP) and these good macroeconomic conditions are expected to continue in the foreseeable future, then management can take a more aggressive stance in financing a company's operations to take advantage of the opportunities. 4. **Prospects of the industry and expected growth rates.** If the industry where a company operates has good prospects and growth rates are expected to be high, management can consider borrowing more to expand operations. Otherwise, if the prospects are bleak, it is better to have low debt ratios. 5. **Bond and stock market conditions.** The ability of a company to raise more funds from the stock market and the bond market also depends on how bullish players are in these markets. If both markets are doing well just like what the Philippines has been experiencing over the last couple of years where its stock market and bond market are both expanding, then it is a good opportunity for the publicly listed companies and even those which are not listed to tap both markets. Big Philippine companies tapped the bond market in 2019 for additional financing. As of October 14, 2019, the number of corporate bonds and other fixed-income instruments listed in PDEx for 2019 amounted to more than P282 billion. 6. **Financial flexibility.** It refers to the ability of a company to raise funds, be it the stock market or the bond market when the need for cash arises. Companies that have low stability or leverage ratios have more financial flexibility as compared to companies that have higher leverage ratios. 7. **Regulatory environment.** There are operations that are heavily regulated such as banks which are regulated by the Bangko Sentral ng Pilipinas (BSP). Banks, as required by BSP have to maintain a minimum level of capital adequacy ratio, a kind of stability ratio applied to banks. 8. **Taxes.** Interest expense provides a tax shield while cash dividend does not provide a tax shield. Interest expenses are allowed to be deducted from operating income to compute taxable income. Therefore, interest expenses reduce tax payments. Cash dividends are not allowed to be deducted from the operating income in computing taxable income. Hence, there are no tax shields from cash dividend payments. 9. **Management style.** Some managers are aggressive and some are conservative. Management style definitely contributes to the kind of capital structure a company has. Management recommends to the Board of Directors the major financing activities a company will embrace. The next section will discuss the different stability or leverage ratios: * **Debt ratio** > The debt ratio measures how much of the total assets are financed by liabilities. Below is the formula for debt ratio: * **Debt ratio = Total liabilities + Total assets** > * PDEX refers to Philippine Dealing & Exchange Corp, which provides the facilities for trading fixed income instruments such as government bonds and corporate bonds. > Compute the debt ratio of ADP Foods Company in 2019 (refer to Exhibit 2.2 for the total liabilities and total assets). * **Debt ratio = 9,019,461 + 22,290,020** * **Debt ratio = 0.44** > The debt ratio of less than 0.50 means that the company has less liabilities as compared to its stockholders' equity. If the debt ratio is 0.50, this means that the amount of total liabilities is exactly equal to stockholders' equity. * **Debt-to-equity ratio** > The debt-to-equity ratio is a variation of the debt ratio. Debt to equity ratio of more than one means that a company has more liabilities as compared to stockholders' equity. The formula for the debt-to-equity ratio is shown below: * **Debt-to-equity ratio = Total liabilities + Equity** > Shown below is the computation of the debt-to-equity ratio for ADP Foods Company in 2019 (refer to Exhibit 2.2 for the information about liabilities and equity). * **Debt-to-equity ratio = 9,819,461 + 12,478,559** * **Debt-to-equity ratio = 0.79** > Since the company’s debt ratio in 2019 is 0.44 which is less than 0.50, it is expected that its debt-to-equity ratio is less than one. * **Interest Coverage Ratio** > The interest coverage ratio provides information if a company has enough operating income to cover interest expense. Below is the formula for interest coverage ratio. * **Interest coverage ratio = Operating income + Interest expense** > In some finance textbooks, earnings before interest and taxes (EBIT), instead of operating income, is used as a numerator, instead of operating income. Without other revenues and expenses, operating income is the same as EBIT. The use of operating income as a numerator is better because it represents the earnings from the core business of the company. From the management’s and analysts’ perspective, it is important to know how many times operating income can cover interest expense. Let us compute the interest coverage ratio of ADP Foods Company in 2019 (refer to Exhibit 2.1 for the information on interest expense and operating income). * **Interest coverage ratio = 4,048,696 ÷ 250,000** * **Interest coverage ratio = 16.19** > The interest coverage ratio of 16.19 means that ADP Foods Company has more than enough operating income to cover its interest expense. It has an operating income which is a little more than 16 times its interest expense in 2019. This high interest coverage ratio is also a reflection of a more conservative capital structure ADP Foods Company has, as reflected in its low leverage ratios. > *When faced with a more complex income statement, earnings before interest and taxes (EBIT) is computed by adding income taxes and interest expense to the reported net income.* ### Quality of Earnings In analyzing a statement of profit or loss, how can you tell whether the earnings are of good or poor quality? There are information in the financial statements that should be looked into. Among these are the following: 1. *Is the income coming from the core business?* If so, then it is good. But if income comes from the nonrecurring transaction such as the sale of equipment when the company is not in the business of selling equipment, then the income is not of good quality because this income is not expected to happen again, or at least, not in the foreseeable future. 2. *How much of the net income translate into cash flows?* Recognition of revenues is based on the accrual principle so not all the revenues recognized during the period are necessarily collected. The same is true for expenses. As an analyst, however, it is important to know if the net income reported in the statement of profit or loss translates into cash flows. This information can be found in the first section of the statement of cash flows, the cash flows from operating activities. 3. *Is the income stable?* The stability of earnings is influenced by the nature of the business a company is in. Utility companies that provide basic services such as power distribution companies are supposed to be more stable. Food companies that cater to the masses such as Jollibee Foods Corporation can also be considered stable. Mining and oil companies whose prices of the commodities they sell fluctuate a lot can be considered more unstable. ### Limitations of Financial Statement Analysis While financial statement analysis is a very powerful tool in understanding a company, it has its limitations, too. Among them are: 1. Financial analysis deals only with quantitative data. But we know that behind the success of every company are important personalities. The value of these personalities is not reported in the statement of financial position. This is why in analyzing a company, it is not enough to just look at the financial statements. One has to figure out the controlling stockholders and the top executives behind these companies