This document discusses financial ratio analysis. It begins by outlining the six key principles of accounting: recording, classifying, summarizing, analyzing, interpreting, and reporting. It then discusses the five major categories of financial ratios - liquidity, asset management, debt management, profitability, and market value - and what key financial questions they aim to answer. The document provides examples of various ratios under each category, such as current ratio, debt-to-equity ratio, return on assets, and price-to-earnings ratio. It concludes by noting some limitations of ratio analysis, such as reliance on accurate financial data and accounting policies.

1. Muhammad Aqib Ali
Accounting Principles

2. Accounting Demystified
 Recording;
 Classifying;
 Summarizing;
 Analyzing;
 Interpreting; and finally
 Reporting.

3. Financial Statements
Analysis

4. Outline
 Purpose of Financial Analysis.
 Types of Ratio Analysis.
 Financial Statements.
 Users of Financial Statements.
 Ratio Analysis:
 Liquidity Ratios.
 Activity Ratios.
 Profitability Ratios.
 Capital Structure / Leverage Ratios.
 Market Value Ratios.
 Limitations of Ratio Analysis.

5. Purpose of Financial Analysis
 Assessment of the firm’s past, present and
future financial conditions.
 Find organization’s financial strengths and
weaknesses.
 To make informed decisions about a
company.
 Helps forecast its future profitability and risk.
 Assists to improve non-financial performance
of the company.

6. Using Financial Ratios
 Major tool for financial analysis.
 Standardize numbers and facilitate
comparisons.
 Analyze the firm’s financial position &
financial performance.
 Ratios are used to highlight weaknesses
and strengths.
 Better & easy to understand information
for the users.

7. Financial Statements
 Income Statement (Profit & Loss Account )
 Balance Sheet
 Cash Flow Statement
 Statement of Changes in Equity
 Notes to the Accounts
 Auditor’s Report / Director’s Report

8. Income Statement
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses (Selling & Administration)
Operating Income
Add: Other Incomes
Profit Before Interest & Tax
Financial Charges
Profit Before Tax
Provision for Taxation
Profit After Tax
Profit B/F
Profit Available for Appropriations
Transfer to General Reserves
Dividends
Profit C/F (Transferred to Balance Sheet)
Rs.
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9. Balance Sheet
Equity & Liabilities Rs. Assets & Properties Rs.
Share Capital &
Reserves:
Non-Current
Liabilities:
Current Liabilities:
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Non-Current
Assets:
Long Term
Investments:
Current Assets:
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10. Users of Financial Statements
 Internal Users
 External Users

11. Internal Users
 Management
 Employees
 Internal Auditors

12. External Users
 Investors
 Shareholders
 Customers
 Tax Authorities
 Banks & Other Financial Institutions
 Creditors
 Suppliers
 External Auditors
 Government Agencies

13. Types of Ratio Analysis
 Horizontal Analysis
 Vertical Analysis

14. Horizontal OR Trend Analysis
 The corresponding ratios of a same firm for
different periods.
 The corresponding ratios for another firm.
 The firm’s ratios compared with that of the
Industry’s Overall Average.
 The ratios of one division/department of a
firm against another division or department.
 The planned ratios for the period.

15. Vertical Analysis
 Shows relationship of each item to a base
amount on financial statements.
 Income statement – each item expressed
as percentage of net sales.
 Balance sheet – each item expressed as
percentage of total assets.

16. Ratio Analysis
 Financial Ratios can be classified into 5
main categories:
 Liquidity OR Short-Term Solvency Ratios
 Asset Management OR Activity Ratios
 Profitability Ratios
 Capital Structure OR Leverage Ratios
 Market Test OR Market Value Ratios

17. What are the five major categories of ratios,
and what questions do they answer?
 Liquidity: Can we make required payments?
 Asset management: right amount of assets vs.
sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
 Market value: Do investors like what they see as
reflected in P/E and M/B ratios?

18. Liquidity OR Short-Term Solvency
Ratios
 Net Working Capital =
Current Assets - Current Liabilities
 Current Ratio = Current Assets
Current Liabilities
 Acid Test/Liquid/Quick Ratio =
(Current Assets – Prepaid Expenses – Stock [Closing] – Loose Tools)
Current Liabilities

19. Activity OR Asset Management
Ratios
 Stock Turnover Ratio: CGS
Avg. Stock
 Debtors Turnover Ratio: Total Credit Sales
Average Debtors
 Average Collection Period:
Average Debtors X 360
Total Credit Sales

20. Activity OR Asset Management
Ratios
 Creditors Turnover : Total Credit Purchases
Average Creditors
 Average Payment Period:
Average Creditors X 360
Total Credit Purchases
 Total Assets Turnover Ratio:
CGS OR Sales
Total Assets

21. Profitability Ratios
 Sales: Rate of return on net sales (Profit
Margin)
 Investment (Assets): Rate of return on
total assets – how successful the business
is in using assets to earn a profit

22. Profitability Ratios (Sales)
 GP Ratio: Gross Profit X 100
Net Sales
 Net Profit Ratio: Profit After Tax X 100
Net Sales
 Operating Profit Ratio:
Operating Profit X 100
Net Sales

23. Profitability Ratios (Sales)
 Cost of Goods Sold Ratio:
CGS x 100
Net Sales
 Operating Ratio:
CGS + Operating Expenses X 100
Net Sales

24. Profitability Ratios
{Investment (Assets)}
 Return on Investment (ROI):
Profit After Tax X 100
Total Assets
 Return on Equity Funds (ROE):
Profit After Tax – Preference Dividend X 100
Ordinary Shareholders Equity

25. Profitability Ratios
{Investment (Assets)}
DuPont Analysis
 Three ways to ascertain Return on Equity:
 (A) Return on Equity Funds (ROE):
Profit After Tax – Preference Dividend X 100
Ordinary Shareholders Equity
 Ordinary Shareholders Funds/Equity: Ordinary Share
Capital + Reserves + Surplus

26. Profitability Ratios
{Investment (Assets)}
DuPont Analysis
 (B) Return on Equity = N.P Margin x Total
Assets Turnover x Financial Leverage:
Net Income x Revenues x Avg. Total Assets
Revenues Avg. T. Assets Avg. Sh. Equity
 ROE = (Profit margin) x (Asset turnover)
x (Equity multiplier)

27. Profitability Ratios
{Investment (Assets)}
DuPont Analysis
 ROE = (Profit margin) x (Asset turnover)
x (Equity multiplier)
 (Net profit/Sales) x Sales/Assets) x (Assets/Equity)
= (Net Profit/Equity)
 Operating efficiency (measured by profit margin)
 Asset use efficiency (measured by asset turnover)
 Financial leverage (measured by equity multiplier)

28. Profitability Ratios
{Investment (Assets)}
 Return on Capital Employed (ROCE):
Profit After Tax + Interest X 100
Total Capital Employed
 Total Capital Employed: Ordinary Share Capital + Preference
Share Capital + Reserves (Capital & Revenue) + Surplus + Long
Term Liabilities
 Return on Total Assets (ROA):
Profit After Tax + Interest X 100
Total Assets

29. Capital Structure OR Leverage OR
Long – Term Solvency Ratios
 Debt – Asset Relationship (Balance
Sheet Based )
 Coverage Ratios ( P & L A/C Based )

30. Debt – Asset Ratios
 Debt – Equity Ratio: Long – Term Liabilities X 100
Equity Share Capital
 Equity Share Capital => Ordinary Share Capital + Preference
Share Capital + Reserves + Surplus
 Debt – Total Capital: Long – Term Liabilities X 100
Total Capital
 Total Capital =>Equity Share Capital + Long Term Liabilities

31. Debt – Asset Ratios
 Debt Ratio OR Debt to Total Assets:
Total Debts X 100
Total Assets
 Total Debts => Long Term Liabilities + Short Term Liabilities
 Capital Gearing Ratio:
Fixed Cost Capital X 100
Shareholders Equity + Long Term Liabilities
Fixed Cost Capital =>Preference Share Capital + Debentures +
Other Borrowed Funds.
 If Capital Gearing Ratio is:
 Greater Than 50% - High Geared.
 Equal to 50% - Neutral Geared.
 Lower Than 50% - Low Geared.

32. Coverage Ratios
 Interest Coverage Ratio:
Profit Before Tax & Interest
Interest
 Dividend Coverage Ratio:
Profit After Tax
Preference Dividend

33. Market Value/Test Ratios
 Earnings per share = Net Profit after tax
Number of issued ordinary shares
 Dividend per share = Dividends
Number of issued ordinary shares
 Market to Book Value (M/B) Ratio = Market price per share
Book value per share
 Price Earnings (P/E) Ratio = Market price per share
Earnings per share

34. Limitations of Ratio Analysis
 Basic financial data must be reliable or
the results may be misleading.
 Ratio Analysis only considers financial
data financial data share the same
problems of financial data (such as
timeliness).
 Different firms use different accounting
policies e.g. Depreciation method.

35. Limitations of Ratio Analysis
 Comparing ratios over time is complicated by
the fact that economic conditions may change
also such as inflation, interest rate, prices etc.
 Comparing ratios between two firms is
complicated by the fact that the firms may have
different economic environments or production
technologies even though they produce the
same product.
 Ratio analysis is only numerical and calculated
values which may be based on accounting
estimates.

36. Thanks !