On the basis of financial accounting, ratio analysis is defined as the systematic
use of ratio to interpret the financial statements so that the strengths and
weaknesses of a firm as well as its historical performance and current financial
condition can be determined.
It is also called accounting ratio.
Use of Ratio Analysis:
Ratio Analysis is primarily used in financial accounting to explain financial
position of a company on the basis of 5 ratios which are further categorized in
many different ratios.
Types of Ratio
These five types of ratios are given below:
The term Liquidity actually explains the ability of a firm or a company to pay its liabilities
within the given time interval.
Liquidity ratio consists of two types of ratios:
Acid Test(Quick Ratio)
Acid test tells you that by how much a company is owed by omitting the stock from the
current assets to show that how much cash the firm has in relation to its liabilities (what it
Also known as the ‘Quick ratio’
(Current assets – stock) : liabilities
Its ideal value is
Example of Acid Test :
Current Assets= $150000
Current Liabilities= $100000
2. Current Ratio:
Current Ratio tells about the ratio between the current assets and current liabilities.
Current Ratio = Current Assets : Current Liabilities
Its ideal value is 2:1
Example of Current Ratio:
Current Liabilities = $80000
It is a below the ideal level.
Investment ratios gives you information to enable decisions to be made on the
extent of the risk and the earning potential of a business investment.
Consists of three types of ratios:
1.Earnings per share:
Gives you the profit per unit share.
Profit after tax / Number of shares
Net Profit= 1000000
Number of Shares= 400000
=1000000 ÷ 400000
=$2.5 per share
Earnings per Share is 2.5.
2.Price earnings ratio:
Gives you the market price of a unit or single
Market price / Earnings per share
Market Price per share= $10
Earnings per share=$1
Price Earning Ratio=10/1
Relates the return on the investment to the share price.
Ordinary share dividend / market price x 100
Company M has an EPS of $4 in FY 2011, its dividend payout
ratio is 50% and its share price is $20. Calculate the dividend
Dividend per Share = EPS × Dividend Payout Ratio = $4 × 0.5 =
Dividend Yield = $2/$20 = 10%
Profitability actually tells you that how much profit the firm can generate by sales or
through its capital assets.
There are two types of profitability ratios:
1.Gross Profit :
Gives you the difference between total revenue and variable costs.
Total revenue (turnover) – variable costs (cost of sales)
Gives you the difference between total revenue and all costs.
Total revenue (turnover) – variable costs and fixed costs (overheads)
Gross Profit Margin:
Gross Profit Margin enables the firm to assess the impact of its sales and
how much it cost to generate such sales.
Gross Profit Margin = Gross profit / turnover x 100
Gross Profit= $400000
Gross Profit Margin= 400000/1000000 x 100
Net Profit Margin:
Net profit gives information about the fixed costs involved in
production also known as the overheads.
Net Profit Margin = Net Profit / Turnover x 100
Net Profit= $200000
Turnover = $1000000
Net Profit Margin= 200000/1000000 x 100
Return on Capital Employed:
Gives you a review about the amount of returns you get on the
amount you initially invested in the company.
Return on Capital Employed (ROCE) = Profit / capital
employed x 100
Earnings before interest and tax= $250000
Total Capital Employed= $1250000
Return on Capital Employed= 250000/1250000 x 100
Explains the financial position of the company, relationship
between the loans and the capital.
Gearing Ratio = Long term loans / Capital employed x 100
The higher the ratio the more the business is exposed to interest rate
fluctuations and to having to pay back interest and loans before being
able to re-invest earnings
Total Capital Employed= 10 million
Long term liability= 4 million
The gearing ratio of the company is 40 percent.
Financial Ratios comprises of three ratios:
Explains how assets are utilized to generate profits.
Asset Turnover = Sales turnover / assets employed
Assets = 100000
Now we will use the formula to calculate asset turnover.
= 200000÷ 100000
The asset turnover ratio is 2 which is good
Explains the rate at which a company’s stock is turned over.
Stock turnover = Cost of goods sold / stock expressed as times per
It shows that company’s stock was sold 20 times in a year.
Ratio Analysis is used to determine liquidity, profitability, investment
probabilities and financial position of a firm.
It helps us to compare with other businesses and tells us about the ratios of
other industries and tells us where we stand in the industry.
It also tells us where we can improve and in which section we are good.
Queries and Comments
Mehfooz Ali Khan
Mir Abdur Rehman
The End and Thank you!