Ratios
(1)
Financial Ratios help the users to assess the
Financial position of the entity
Financial performance of the entity
Users of financial Statements
Investors & potential investors
Lenders
Suppliers
Customers
Public
Employees
Government & its Agencies
Competitors
General Public
Uses of ratios
Comparing actual data with budgeted data
Comparison with the competitors
Comparison with the Industry averages
Comparison with past years
Categories of financial ratios
Liquidity / Short Term Solvency
AH
I.
II.
(2)
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
(3)
I.
II.
III.
IV.
(4)
I.
CAF-5
M
To assess the ability to meet the short term obligation (Short term Solvency)
II.
Profitability
To assess the financial performance
III.
Activity / Efficiency / Turnover / working capital turnover
To assess efficient utilization of assets / investment in WC
IV.
Debt / Gearing / Leverage / Long term Stability
To assess the ability to meet the Long term obligation (Long term Solvency)
V.
Potential Investor / investment / Market
To assess the profit / return on investor's investment
ADVANTAGES OF RATIOS ANAYLYS
1.
2.
3.
4.
It simplifies the financial statements.
It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over a period.
It highlights important information in simple form quickly. A user can judge a company by just looking at few
numbers instead of reading the whole financial statements.
LIMITATIONS OF RATIO ANALYSIS
1. Inflation may distort comparison over time.
2. Different accounting policies may distort inter - company comparison
3. The accounting information used to prepare the ratios may be out of date.
4. The information presented in publish accounts in usually precise making the detailed analysis impossible.
5. Using industry average as basis for comparison may be misleading as they are averages of ratios from multiple
companies.
6. Changes in accounting policies from year to year may genearate misleading ratios.
I.
LIQUIDITY / SHORT TERM SOLVENCY
To assess the ability to meet the short term obligation (Short term Solvency)
1
Ratios
CAF-5
(A) Working Capital
Current Assets Less Current Liabilities
(B) Current Ratio
Current Assets___
Current Liabilities


AH
It will be in times . 2 :1 is ideal
It represents the margin of safety or cushion available to the creditors. It is an index of the business financial
stability.
HIGHER RATIO
LOWER RATIO
I.
Better liquidity position
I.
Financial difficulty
II.
Larger inventories –Risk of obsolescence
II.
Lower inventories
III.
Less credit purchases
III.
Longer creditor’s credit periods.
(C) LIQUID RATIO / ACID TEST RATIO / QUICK RATIO
Current assets – inventory
Current Liabilities
 It will be in times . 1 :1 is ideal
 It measures the business capacity to pay off current obligations immediately and is more accurate test of
liquidity than the current ratio.
HIGHER RATIO
LOWER RATIO
I.
Better liquidity ratio
I.
Financial difficulty
II.
Longer debtors’ credit period
II.
Lower inventories
III.
Larger creditor period
III.
Shorter debtor’s credit period.
(II)
PROFITABILITY
To assess the financial performance
(A) Gross Profit Ratio (GP Ratio)
Gross Profit x 100%
Net Sales


M
It will be in %. Higher is better
It shows the relationship between gross profit and sales and the efficiency with which a business produces its
products.
HIGHER RATIO
LOWER RATIO
I.
Increase in selling price
I.
Decrease in selling price
II.
Reduction in cost
II.
Increase in cost
III.
Undervaluation of opening stock or
III.
Overvaluation of opening stock or
overvaluation of closing stock
undervaluation of closing stock.
IV.
Achieving of economies of scale
(B) Net Profit Ratio
Net profit x 100%
Net Sales
 It will be in %. Higher is better
 It shows the overall profitability of business. It shows how efficiently the business is being conducted to ensure
higher profits.
HIGHER RATIO
LOWER RATIO
I.
Efficient operating expenses
I.
Uncontrolled expenses
2
Ratios
II.
III.
IV.
V.
Low financial cost.
Low tax rate
Increase of incomes
Gains on disposal
CAF-5
II.
III.
IV.
V.
High financial cost
High tax rate
Low in incomes
Loss on disposals
(C) PBIT over sales Ratio
PBIT x 100%
Net Sales


AH
It will be in %. Higher is better
It shows the overall profitability of business. It shows how efficiently the business is being conducted to ensure
higher profits.
HIGHER RATIO
LOWER RATIO
I.
Efficient operating expenses
I.
Uncontrolled expenses
II.
Increase of incomes
II.
Low in incomes
III.
Gains on disposal
III.
Loss on disposals
(D) Return on Capital Employed ( ROCE )
_______PBIT________ x 100 %
Avg. Capital employed



M
It will be in %. Higher is better
Capital employed = Equity + borrowings(Long term)
It is considered to be the best measure of overall profitability of business and indicates how well the
management has used the investment made by owners and lenders into the business.
HIGHER RATIO
LOWER RATIO
I.
Higher profitability
I.
Lower profitability
II.
Efficient funds management
II.
Inefficient funds management
(E) Return on Equity (ROE)
PAT – Preference dividend(classified as equity) x 100%
Avg. Equity


It will be in %. Higher is better
It measures the overall efficiency of a company. This ration is of great importance to present and prospective
shareholders as well as management.
Higher ratio
Low Ratio
I.
Higher profitability
I.
Lower profitability
II.
Efficient funds management
II.
Inefficient funds management
(F) Return on Assets(ROA)
__________PBIT___________ X 100%
Avg. Assets
 It will be in %. Higher is better
 It measures the overall efficiency of a company in general profits using its assets efficiently.
HIGHER RATIO
LOW RATIO
I.
High profitability
I.
Lower profitability
II.
Efficient asset management
II.
Inefficient asset management
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Ratios
CAF-5
(G) Expense to Sale Ratio
COS/Selling expense/Admin expense x 100%
Net Sales


AH
It will be in %. Lower is better
It shows the relationship between gross profit and sales and the efficiency with which a business produces its
products.
HIGHER RATIO
LOWER RATIO
I.
Decrease in selling price
I.
Increase in selling price
II.
Increase in cost
II.
Decrease in cost
III.
Overvaluation of opening
III.
Overvaluation of opening stock or
stock or undervaluation of
undervaluation of closing stock (COS)
closing stock (COS)
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III. ACTIVITY / EFFICIENCY / TURNOVER / WORKING CAPITAL TURNOVER
To assess efficient utilization of assets / investment in WC
(A) Inventory Turnover Ratio
Cost of Sales
Avg. Inventory
 It will be in times. Higher is better
 It measures the velocity of conversion of stock into sales.
HIGHER RATIO
LOWER RATIO
I.
Efficient inventory Management
I.
Inefficient inventory Management
II.
Higher sales
II.
Lower sales
(B) Inventory Holding Period
____Avg. Inventory____ x 365 days
Cost of sales (Annual)
 It will be in Days. Lower is better
 It measures the period for which the goods remain in stock before getting sold.
 Use 12 instead of 365 then answer will be in Months and Use 52 to have an answer in weeks
HIGHER RATIO
LOWER RATIO
I.
Inefficient inventory Management
I.
Efficient inventory Management
II.
Lower sales
II.
Higher Sales
(C) Debtors Turnover Ratio
_____Credit sales __
Avg. Debtors
 It will be in times. Higher is better
 It measures the velocity of debt collection of business.
HIGHER RATIO
LOWER RATIO
I.
Better control over debtors
I.
Poor control over debtors
II.
Shorter credit periods
II.
Longer credit periods
III.
More discounts offered
III.
Less discounts offered
(D) Debtors Collection Period
_____Average Debtors______ x 365 days
Credit Sales (Annual)
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Ratios
CAF-5


M
AH
It will be in Days. Lower is better but should be within credit period allowed to credit customers
It indicates the number of days for which a business has to wait before its debtors are converted into cash (An
average days after which amounts are collected from debtors)
 If credit sales are not given in question then use Total Sales
 Use 12 instead of 365 then answer will be in Months and Use 52 to have an answer in weeks
HIGHER RATIO
LOWER RATIO
I.
Inefficient collection
I.
Efficient collection
II.
Longer credit Periods
II.
Shorter credit periods
III.
Less discounts offered
III.
More discounts offered
(E) Creditors Turnover Ratio
Credit Purchases_(Annual)__
Avg. Creditors
 It will be in times. Higher is better as it shows credit worthiness. However, higher ratio may indicated that
credit period is not fully availed as legitimate credit period should be availed.
 If credit purchases are not given in the question then use total Purchases
 If Purchases are not given , use cost of sales
 It measures the velocity of paying to payables of the business.
HIGHER RATIO
LOWER RATIO
I.
Timely payment to supplies
I.
Late payment to suppliers
II.
Credit worthiness
II.
Less Credit worthiness
III.
More discounts availed
III.
Less discounts availed
(F) Creditors Payment Period
Average Creditors ____ x 365 days
Credit Purchases(Annual)
 It will be in Days. Lower is better as it shows credit worthiness, but it should be closer to credit period allowed.
 Use 12 instead of 365 then answer will be in Months and Use 52 to have an answer in weeks
 If credit purchases are not given in the question then use total Purchases
 If Purchases are not given , use cost of sales
 It indicates the number of days of credit period enjoyed by the business in paying creditors.
HIGHER RATIO
LOWER RATIO
I.
Late Payment to suppliers
I.
Timely payments to suppliers
II.
Less credit worthiness
II.
Credit worthiness
III.
Less discounts availed
III.
More discounts availed.
(G) Assets Turnover Ratio
Net Sales_______
Avg of (Total Assets Less CL)
AVG of (Equity + LTL)
 It will be in times. Higher is better
 It measures the efficiency and profit earning ability of business assets. It indicated how well the assets are
utilized to earn revenue.
HIGHER RATIO
LOWER RATIO
I.
Efficient utilization of assets
I.
Inefficient use of assets
II.
High productivity of assets
II.
Low productivity
(H) Working capital cycle / Cash operating cycle
Inventory Period + Debtors collection period - Creditors Period
 It will be in Days. Lower is better
5
Ratios
CAF-5

It reflects the period of one operating cycle from when the time suppliers are paid to the time when inventory
is produced and cash is received from customers.
HIGHER RATIO
LOWER RATIO
I.
Lower inventory turnover
IV.
High inventory turnover
II.
Poor control over debtors
V.
Better control over debtors
III.
Timely payment to suppliers
VI.
Late payment to suppliers
(IV)
DEBT / GEARING / LEVERAGE / LONG TERM STABILITY
M
AH
To assess the ability to meet the Long term obligation (Long term Solvency)
(A) Debt Equity Ratio / Gearing Ratio
L.T.Debt
Equity
 1:1 is good but depends upon business
 It indicates the relationship between external finance and internal equity
HIGHER RATIO
LOWER RATIO
I.
Higher debts
I.
Lower debts
II.
Less risk shared by openers
II.
More risk shared by owners
III.
Less solvent business
III.
Better solvency position
Formula 2 ( Recommended)
L.T.Debt
Equity +L.T.D
 1:1 is good but depends upon business
 It indicates the relationship between external finance and Total finance(Internal + external)
HIGHER RATIO
LOWER RATIO
I.
Higher debts
I.
Lower debts
II.
Less risk shared by openers
II.
More risk shared by owners
III.
Less solvent business
III.
Better solvency position
(B) INTEREST COVER / DEBT SERVICE RATIO
_ PBIT
Interest
 It will be in times. Higher is better
 It indicates whether the business earned sufficient profits to pay periodically the interest charges.
HIGH RATIO
LOW RATIO
I.
Higher profitability
I.
Lower profitability
II.
Less use of debts
II.
More use of debts
III.
Ability to make further debts
III.
Less credit worthiness
TYPES OF QUESTIONS
1.
Only Ratio Calculation. May be only current year and may be Current and comparative year as well. Current year
ratio calculation and Comparison with other company
If two years information is available and ratios are required for current year only, then in case of mixed ratios, use
average values I.e.(Opening value + Closing Value) / 2 for balance sheet items. However, if ratios for both year are
required then use respective closing values of each year.
2.
Ratios analysis and comment/Analyze Then
I.
Calculate Ratios
II.
Should know the meaning of ratio
III.
What Could be the possible reason for the change / variation ( 3 or 4 reason depend on Question)
6
Ratios
CAF-5
(S-2017 Q-7)
M
AH
Q-1
CAF-5
Ratios – Past Papers
Q-2
(A-2017 Q-5)
Mirza Ali Hassan , ACA
Page 1
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Ratios
CAF-5
CAF-5
Ratios – Past Papers
M
AH
Q-3 (S-2018 Q-7)
Q-4 (A-2018 Q-7)
Mirza Ali Hassan , ACA
Page 2
8
Ratios
CAF-5
Ratios – Past Papers
AH
CAF-5
M
Q-5 (S-2019 Q-7)
Mirza Ali Hassan , ACA
Page 3
9
Ratios
CAF-5
Ratios – Past Papers
M
AH
CAF-5
Mirza Ali Hassan , ACA
Page 4
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