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1. Lecture 05 Ratio Analysis
Noorulhadi : Lecturer GCMS Peshawar

2. Ratio Analysis
Annual report components that are financial
statements, these statements report current
position and past period. These statements help
to predict future earnings, dividends, and free
cash flow. For investors standpoint its predicting
the future and for management ‘s standpoint it is
useful both for future prediction and for planning
actions that will improve future performance.
Financial ratio are designed to help evaluate a
financial statements.

3. Ratio Analysis
1. Liquidity Ratios:
2. Asset management Ratios:
3. Debt Management Ratios:
4. Profitability Ratios:
5. Market Value Ratio:

4. Liquidity Ratios,:
Ratio Analysis
A Liquid asset is one that trades in an active market and hence can be quickly
converted to cash at the going market price and a firm’s liquidity ratio deal
with that firm will be able to pay off its debts, Liquidity analysis requires the
use of cash budgets, but they related the amount of cash and other current
assets to current obligation.
Two ratios are the components of liquidity ratio:
1. Current Ratio = Current Assets / Current liabilities
• Current asset include cash, marketable securities, account receivable,
and inventories. Current liabilities include account payable, short term
notes payable accrued taxes and expenses.
• For MicroDrive = 1000/310 = 3.2 times while industry average = 4.2
times.
• Creditors like to see high current ratio. Current ratio provide best
indicator to cover the short term creditors.
• From shareholders perspective, high current ratio mean cash is in
useless form.

5. Liquidity Ratio
2. Acid test or quick ratio = (Current asset – inventory ) / Current liability
Or
=Quick Asset / Current Liabilities
Quick Asset = Current asset – Current liabilities
The acid test or quick ratio is calculated by deducting inventories from current assets
and then dividing the remainder by current liabilities.
Quick Ratio= 385/ 310=1.2 times
Industry average = 2.1 times
In case of bankruptcy, inventories may be liquidated on losses. Therefore measuring
of the firm ability without inventories is important.
In this case industry average quick ratio is 2.1, so Micro Drives 1.2 ratio is low.

6. Asset Management Ratio:
These ratios measure that how effectively the
firm is managing its assets. Following ratios are
used for asset management ratio.
1. Inventory Turnover ratio: is defined as sale
divided by inventories
Inventory turnover ratio = sale / inventories.
= 3000 /615= 4.9 times
Industry average = 9 times.
Its indicates that 4.9 times inventory is sold out
and re-stock in one fiscal period.

7. Asset Management Ratio:
2. The Days sale outstanding (Evaluating
Receivables)
It is also known average collection period (ACP)
DSO= Receivable / Average sale per day
Or =Receivable / annual sales/ 360
= 375 / 3000/360 = 45 days
Industry average = 36 days
In this case 15 days refers that customer
outstanding for 15 days.
For better appraisal
= (op A/R + Ending A/R) / Average sale per day

8. Asset Management Ratio:
3. The fixed asset turnover: evaluating fixed asset
The fixed assets turnover ratio measures how
effectively the firm uses plant and equipment; it
is the ratio of sale to net fixed assets =
= Sale / Net Fixed asset
= 3000 / 1000 = 3 times
Industry average = 3 time
This ratio show only the effective usage of plant
and machinery.

9. Asset Management Ratio:
4. Total Asset turnover ratio (evaluating total assets)
It measures the turnover of all the firms’ assets, it is
calculated as
= Sale / Total assets = 3000/ 2000 = 1.5 time
Industry average = 1.8 time
It is indicating the sufficient volume of business with total
investment assets. Sale should be increased by
selling assets.

10. Debt Management Ratio
These ratios reveal the extent to which the firm is
finance to debt, and probability of defaulting on its
debt obligation.
1. Total Debt to Total Asset (how firm is financed)
The ratio of debt to total assets, generally called the debt ratio, its
measured the percentage of fund provided by creditors.
Debt Ratio = Total Debt (current and long) / Total Assets.
= 1064 / 2000 = 53.2%
Creditors prefer low debt ratio because the lower the ratio for
compensation in insolvency, share holder need high debt
ratio, for more investment and expected earning. In this case
the company is more financed by creditors.

11. Debt Management Ratio
2. Time interest Earned Ratio:
It measure the ability to pay interest.,
Time interest earned ratio = EBIT / Interest Charges.
=283.8 / 88 = 3.2 times
Industry average = 6 times
It means micro drive can not afford to borrow more money. Lower
the ratio leads to bankruptcy.

12. Debt Management Ratio
3. EBITDA Coverage Ratio
It measure ability to service Debt, it is most useful
for relatively short term lenders such as
banks,.
EBITDA coverage ratio =
(EBITDA + Lease payment)
/ (Interest + Principal payment +Lease payment)
=(283.8+100+28) / 88 + 20 + 28
=3 times Industry average = 4.3 times

13. Profitability Ratio
• Profitability ratio shows the combined effects
of liquidity, asset management and debt
management policies on operating result.
1. Profit Margin on Sale = Net income / Sale
The profit margin on sale measure the profit per
dollar sale.
=113.5 / 3000 = 3.8 % Industry average = 5%
It is less than industry average because, cost is
too high by operation.

14. Profitability Ratio
2. Basic Earning Power (BEP) Ratio
This ratio shows the raw earning power of the
firm’s assets before the influence of taxes and
leverage.
= BEP Ratio = EBIT / Total Assets
= 283.8 / 2000 = 14.2% Industry average = 17.2%
It also indicate return on assets.

15. Profitability Ratio
3. Return on Total Assets (ROA)
This ratio measure the return on total assets.
ROA = Net income / Total Asset
= 113.5 / 2000 = 5.7 % Industry avg = 9%
ROA could be lower because of low basic earning power
and high interest cost.
4. Return of Common Equity (ROE)
It measure return on common equity which is the bottom
line. = Net income / Common equity
=113.5 / 896 = 12.7% industry avg = 15%
Stockholders invest to get a return on their money and
this ratio helps to postulate the performance on
ROE.

16. Market Value Ratio
Market value ratios relate the firm’s stock
price to its earning, cash flow and book
value per share, thus giving management
an indication of what investors think of the
company’s past performance and future
prospects. These include the price/earning
ratio, price/cash-flow ratio and the
market /book ratio.

17. Market Value Ratio
1. Price/ Earning Ratio: The P/E ratio shows
how much investors are willing to pay per
dollar of reported profit.
= Price per share / Earning Per Share
= 23/2.27 = 10.1 times, Industry avg = 12.5
Higher ratio indicate high growth potential
and also risk is associated with it.

18. Market Value Ratio
Price / Cash Flow Ratio
In some companies stock price is tied more
closely with cash flow rather than net
income.
= Price per share / Cash flow per Share
=23 / 4.27 = 5.4 times, industry avg =6.8 times
Net cash flow is calculated as Net income plus
depreciation and amortization.

19. Market Value Ratio
Market/Book Ratio
The ratio of a stock’s market price to its book value gives another
indication of how investors regard the company.
Book Value per Share = Common Equity / Share Outstanding .
=896 /50 = 17.92
M/B Ratio = Market Price per share / Book value per share.
=23 / 17.92 = 1.3 times industry avg = 1.7 times