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What are Financial Ratios?

Financial ratios are created with the use of numerical values taken from financial statements to
gain meaningful information about a company. The numbers found on a company’s financial
statements – balance sheet, income statement, and cash flow statement – are used to Page | 1
perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins,
profitability, rates of return, valuation, and more. The term ratio analysis is used to refer to
the investigation of the quantitative relationships between two variables. Financial experts
use these ratios as tools for evaluating different financial statements. Ratios can be used to
compare inter firm & intra firm financial performance and financial position. (Inter firm is
between two companies where as intra firm is within one company.)

Financial ratios are grouped into the following categories:

1. Liquidity ratios
2. Leverage ratios
3. Activity/Efficiency ratios
4. Profitability ratios
5. Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values
over time is done to spot trends that may be developing in a company. For example, an
increasing debt-to-asset ratio may indicate that a company is overburdened with debt and
may eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a
company is performing better or worse than the industry average. For example, comparing
the return on assets between companies helps an analyst or investor to determine which
company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the

company:

External users: Financial analysts, retail investors, creditors, competitors, tax authorities,
regulatory authorities, and industry observers

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Commerce Department Baghdad Campus IUB

Internal users: Management team, employees, and owners

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Commerce Department Baghdad Campus IUB

Importance, Significance, and Merits of Ratio Analysis

The main points of importance are as follows:

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1. Test of solvency. Ratios can illuminate the solvency of a firm. For example, when the
ratio of current assets to current liabilities is increasing, this indicates sufficient
working capital. Thus, creditors can be paid easily.

2. Helpful in decision-making. The main aim of financial statements is to inform users

about the financial position of the company, as well as to serve as a decision-making
aid for managerial personnel.

3. Helpful in financial forecasting and planning. Ratios are critical in financial

planning and forecasting. For example, if a firm's current ratio is 5:1, this means that
capital is blocked up. As the ideal ratio is 2:1, we have 5:1, meaning that $3 is
unnecessarily blocked.

4. Useful in discovering profitability. Ratios are also useful when comparing the
profitability of different companies. Present and past ratios can be compared, for
example, to discover trends in the historical and future performance of companies.

5. Liquidity position. With the use of ratio analysis, meaningful conclusions can be
obtained about the sound liquidity position of the firm. A firm's liquidity position is
sound if it can pay its debts when these are due for payments.

6. Useful for operating efficiency. From a management perspective, ratios enable

managers to measure the efficiency of assets. When sales and their contribution to net
profit increase every year, this is a test of higher efficiency.

7. Business trends. Ratio analysis can expose trends that managers may use to take
corrective actions.

8. Helpful in cost control. Ratios are useful to measure performance and facilitate cost
control.

9. Helpful in analyzing corporate financial health. Ratio analysis can provide

information about liquidity, solvency, profitability, and capital gearing. Thus, they are
valuable for learning about financial health.

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Commerce Department Baghdad Campus IUB

The limitations of ratio analysis

Some of the most important limitations of ratio analysis include:

1. Historical Information: Information used in the analysis is based on real past results Page | 4
that are released by the company. Therefore, ratio analysis metrics do not necessarily
represent future company performance.
2. Inflationary effects: Financial statements are released periodically and, therefore,
there are time differences between each release. If inflation has occurred in between
periods, then real prices are not reflected in the financial statements. Thus, the
numbers across different periods are not comparable until they are adjusted for
inflation.
3. Changes in accounting policies: If the company has changed its accounting policies
and procedures, this may significantly affect financial reporting. In this case, the key
financial metrics utilized in ratio analysis are altered, and the financial results recorded
after the change are not comparable to the results recorded before the change. It is up
to the analyst to be up to date with changes to accounting policies. Changes made are
generally found in the notes to the financial statements section.
4. Operational changes: A company may significantly change its operational structure,
anything from their supply chain strategy to the product that they are selling. When
significant operational changes occur, the comparison of financial metrics before and
after the operational change may lead to misleading conclusions about the company’s
performance and future prospects.
5. Seasonal effects: An analyst should be aware of seasonal factors that could potentially
result in limitations of ratio analysis. The inability to adjust the ratio analysis to the
seasonality effects may lead to false interpretations of the results from the analysis.
6. Manipulation of financial statements: Ratio analysis is based on information that is
reported by the company in its financial statements. This information may be
manipulated by the company’s management to report a better result than its actual
performance. Hence, ratio analysis may not accurately reflect the true nature of the
business, as the misrepresentation of information is not detected by simple analysis. It

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Commerce Department Baghdad Campus IUB

is important that an analyst is aware of these possible manipulations and always

complete extensive due diligence before reaching any conclusions.

1-PROFITABILITY RATIOS
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1.1 Gross Profit ratio

Formula GP ratio = Gross profit x 100

% Net Sales
Here:
Net Sales = Sales – Sales returns

Comment
Ratio result- “higher” is better

Meaning- It shows the relationship between gross profit and sales and
the efficiency with which a business produces its product.

Reasons for- High ratio Low ratio

 Increase in selling price  Decrease in selling price
 Reduction in cost  Increase in cost
 Undervaluation of opening  Overvaluation of opening
stock or overvaluation of stock or undervaluation of
closing stock closing stock

1.2 Net Profit Ratio

Formula NP ratio = Net profit x 100

% Net Sales
Here:
Net profit = Profit after tax
Net Sales = Sales – Sales returns
Comments
Ratio result- “higher” is better
Meaning- It shows the overall profitability of business. It shows how
efficiently the business is conducting its operations to ensure
higher profits.
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Commerce Department Baghdad Campus IUB

Reasons for- High ratio Low ratio

 Efficient operating expenses  Uncontrolled expenses
 Low finance cost  High finance cost

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2-LIQUIDITY/SHORT TERM SOLVENCY RATIOS

2.1 Current ratio
Formula Current ratio = Current assets
Current Liabilities
Here:
Current assets = All current assets including prepayments.
Current Liabilities = All current liabilities including Bank
Overdraft

Comment
Ratio result- “near 2:1” is normal / standard
Meaning- It represents the margin of safety or cushion available to the
creditors. It is an index of the business financial stability.
Reasons for- High ratio Low ratio
 Better liquidity position  Financial difficulty
 Larger inventories  Lower inventories
 Less credit purchases  Longer creditor’s
credit periods
2.2 Liquid ratio/acid test ratio/quick ratio
Formula Quick ratio = Current asset –Inventory-prepayments
Current liabilities

Here:
Current liabilities = All current liabilities including Bank
Overdraft.
Comment
Ratio result- “near 1:1” is normal
(standard)
Meaning- It measures the business’s capacity to pay off current
obligations immediately and is more accurate test of
liquidity than the current ratio.

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB

Reasons for- High ratio Low

 Better liquidity position
 Longer debtors’ credit
period
ratio
 Financial difficulty
 Lower inventories
 Shorter debtors’ Page | 7
credit period

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB
3-ACTIVITY/ WORKING CAPITAL RATIOS
3.1 Inventory turnover ratio
Formula Inventory turnover = Cost of sales times
Avg. Inventory
Comment
Ratio result- “higher” is better Page | 8

Meaning- It measures the velocity of conversion of stock into sales.

Reasons for- High ratio Low ratio

 Efficient inventory  Inefficient inventory
management management
 Higher sales  Lower sales

3.2 Inventory period

Formula Inventory period = Avg. Inventory x 365 days
Cost of sales
Comment
Ratio result- “lower” is better

Meaning- It measures the period for which goods remain in stock before
getting sold.

Reasons for- High ratio Low ratio

 Inefficient inventory  Efficient inventory
management management
 Lower sales  Higher sales

3.3 Debtors turnover ratio

Formula Debtors turnover = Credit sales times
Avg. Debtors
Note:
If Credit sales are not given in question then use
“Total sales”
Comment
Ratio result- “higher” is better
Meaning- It measures the velocity of debt collection of the business.

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB

Reasons for- High ratio Low ratio

 Better control over debtors  Poor control over debtors
 Shorter credit periods  Longer credit periods
 More discounts offered  Less discounts offered

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3.4 Debtors collection period
Formula Debtors collection period = Average debtors x 365 days
Credit sales

Note:
If Credit sales are not given in question then use “Total
sales”
Comment
Ratio result- “Lower” is better

Meaning- It indicates the number of days for which a business has to

wait before its debtors are converted into cash.

Reasons for- High ratio Low ratio

 Poor control over debtors  Better control over debtors
 Longer credit periods  Shorter credit periods
 Less discounts offered  More discounts offered

3.5 Creditors turnover ratio

Formula Creditors turnover ratio = Credit purchases times
Avg. Creditors

Note:
If Credit purchases are not given in the question then use
“Total Purchases”
If Purchases are not given then use “Cost of sales”

Comment

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Commerce Department Baghdad Campus IUB

Ratio result- Generally “higher” is better as it shows credit worthiness,

however higher ratio may indicate that credit period is not fully
availed.
Meaning- It measures the velocity of paying to creditors of the business.
Reasons for- High ratio Low ratio Page | 10
 Timely payment to suppliers  Late payment to suppliers
 Credit worthiness  Less credit worthiness
 More discounts availed  Less discounts availed

3.6 Creditors payment period

Formula Payment period = Average creditors x 365 days

Credit purchases

Note:
If credit purchases is not given in question then use “Total
Purchases” or “Cost of sales”
Comment
Ratio result- Generally “lower” is better as it shows credit worthiness,
however lower ratio may indicate that credit period is not
fully availed.
Meaning- It indicates the number of days of credit period enjoyed by
the business in paying creditors.
Reasons for- High ratio Low ratio
 Late payment  Timely payment to suppliers
to suppliers  Credit worthiness
 Less credit worthiness  More discounts availed
 Less discounts availed
3.7 Assets turnover ratio
Formula Assets turnover = Sales times
Assets
Here:
Sales = Sales – sales return
Assets = Non-current assets + Current assets – Current liabilities
OR alternatively Assets = Non-current assets

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Commerce Department Baghdad Campus IUB

Comments
Ratio result- “higher” is better
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Meaning- It measures the efficiency and profit earning capacity of
business assets. It indicates how well the assets are utilized to
generate revenue.

Reasons for- High ratio Low ratio

 Efficient utilization of assets  Inefficient use of assets
 High productivity of assets  Low productivity

3.8Working capital

cycle

Formula Working capital cycle= [Inventory period + debtors

collection period – creditors period] days

Comments
Ratio result- “Lower” is better

Meaning- It reflects the period for which a firm’s investment is

maintained in working capital as it moves through the
production process towards sales.

Reasons for- High ratio Low ratio

 Low inventory turnover  High inventory turnover
 Poor control over debtors  Better control over debtors
 Timely payment to suppliers  Late payment to suppliers

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Commerce Department Baghdad Campus IUB

4- LONG TERM SOLVENCY / LEVERAGE RATIOS

4.1 Debt to assets ratio

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Formula Debt to asset ratio = Debt x 100 %
Total assets
Here:
Debt = Non current liabilities (including current portion)
Total assets = Equity + Non current liabilities
(including current portion)
Comments
Ratio result- It depends upon nature of business that which ratio is better

Meaning- It measures the portion of total finance of a business, relating to

outsiders.

Reasons for- High ratio Low ratio

 High amount of debts  Lower debt
 Less ability to pay off debts  Better solvency position

4.2 Debt Equity Ratio / Gearing ratio

Formula Debt Equity ratio = Debt [x : y or in %]

Equity
Here:
Debt = Non current liabilities
Equity = Capital and all reserves
Comment
Ratio result- Generally “1:1” is standard, however, it largely varies from
business to business.

Meaning- It indicates the relationship between external finance and internal

finance.

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Commerce Department Baghdad Campus IUB

Reasons for- High ratio Low ratio

 Higher debts  Lower debts
 Less risk shared by owners  More risk shared by owners
 Less solvent business  Better solvency position

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4.3 Interest cover / Debt service ratio

Formula Interest cover = PBIT times

Interest
Here:
PBIT= Operating Profit = Profit before interest and tax
Interest = finance cost for the year
Comment
Ratio result- “higher” is better

Meaning- It indicates whether the business earned sufficient profits to

pay periodically the interest charges.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Less use of debts  More use of debts
 Ability to take further debts  Less credit worthiness

From the desk of Jahanzaib Butt

Commerce Department Baghdad Campus IUB

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From the desk of Jahanzaib Butt