Ratios

1-PROFITABILITY RATIOS

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.

Reasons for- High ratio Low ratio

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

By Nasir Abbas FCA 1

 Ratios
1.3 Return on capital employed (ROCE)

Formula ROCE = PBIT x 100%

Avg. Capital Employed
Here:
PBIT = Operating Profit = Profit before interest (after
interest of overdraft) & tax

Capital employed = Non-current assets + Current assets –

Current liabilities (excluding current portion of NCL)
OR
Capital employed = Equity + Non- current liabilities
(including current portion of NCL)
Comments
Ratio result- “higher” is better

Meaning- It is considered the best measure of overall profitability of

business and indicates how well the management has used the
investment made by owners and creditors into the business.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Efficient funds management  Inefficient funds
management

1.4 Return on equity (ROE)

Formula ROE = Net Profit x 100%

Avg. Equity
Here:
Net Profit = Profit after tax
Equity = Capital and all reserves
Comments
Ratio result- “higher” is better

Meaning- It measures the overall efficiency of a company. This ratio is of

great importance to present and prospective shareholders as
well as management.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Efficient funds management  Inefficient funds
management

By Nasir Abbas FCA 2

 Ratios
2- INVESTORS RATIOS

2.1 Earnings per share (EPS)

Formula EPS = Net Profit

No. of ordinary shares

Here:
Net Profit =Profit after tax

Comments
Ratio result- “higher” is better

Meaning- It shows the earnings of the company per ordinary share basis.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Efficient funds management  Inefficient funds
management

2.2 Price to Earnings ratio (P/E ratio)

Formula P/E Ratio = MPS times

EPS
Here:
MPS = Market price per share
EPS = Earnings per share

Comments
Ratio result- Generally “higher” is better

Meaning- It helps the investor in deciding whether to buy or not to buy

the shares. It also helps in knowing whether the shares of a
company are under or overvalued.

Reasons for- High ratio Low ratio

 Growth prospects  No growth prospects
 Overvalued share  Undervalued share

By Nasir Abbas FCA 3

 Ratios
2.3 Dividend per share (DPS)

Formula DPS = Dividend

No. of ordinary shares
Here:
Dividend = Total ordinary dividend

Comments
Ratio result- “higher” is better

Meaning- It shows the dividend a prospective investor may expect to get

on per share basis.

Reasons for- High ratio Low ratio

 High dividend payout  Low dividend payout
 Higher profitability  Lower profitability
 High required return  Low required return

2.4 Dividend Cover

Formula Dividend cover = PAT times

Dividend
Here:

PAT = Net Profit after tax for the year

Dividend = Total ordinary dividend

Comment
Ratio result- “higher” is better

Meaning- It indicates whether the business earned sufficient profits to

pay periodically the ordinary dividend.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Low dividend payout  High dividend payout
 Ability to pay dividends  Difficulty in paying
dividend

By Nasir Abbas FCA 4

 Ratios
2.5 Earning yield

Formula Earning yield = EPS x 100 %

MPS
Here:
MPS = Market price per share
EPS = Earnings per share

Comments
Ratio result- “higher” is better

Meaning- It measures the return which will be earned on investment in

share.

Reasons for- High ratio Low ratio

 Higher profitability  Lower profitability
 Undervalued share  Overvalued share

2.6 Dividend yield

Formula Dividend yield = DPS x 100%

MPS
Here:
DPS = Dividend per share
MPS = Market price per share
Comment
Ratio result- “higher” is better

Meaning- It helps the prospective investor in knowing the effective

return he will receive on proposed investment.

Reasons for- High ratio Low ratio

 High required return  Low required return
 Undervalued share  Overvalued share

By Nasir Abbas FCA 5

 Ratios
3-LIQUIDITY/SHORT TERM SOLVENCY RATIOS

3.1 Current ratio

Formula Current ratio = Current assets [x : 1]

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

3.2 Liquid ratio/acid test ratio/quick ratio

Formula Quick ratio = Current asset –Inventory-prepayments [x : 1]

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.

Reasons for- High ratio Low ratio

 Better liquidity position  Financial difficulty
 Longer debtors’ credit period  Lower inventories
 Shorter debtors’ credit
period

By Nasir Abbas FCA 6

 Ratios
4-ACTIVITY/ WORKING CAPITAL RATIOS

4.1 Inventory turnover ratio

Formula Inventory turnover = Cost of sales times

Avg. Inventory
Comment
Ratio result- “higher” is better

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

4.2 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

4.3 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.

By Nasir Abbas FCA 7

 Ratios
Reasons for- High ratio
 Better control over debtors
 Shorter credit periods
 More discounts offered
Low ratio
 Poor control over debtors
 Longer credit periods
 Less discounts offered

4.4 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

4.5 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
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

 Timely payment to suppliers  Late payment to suppliers
 Credit worthiness  Less credit worthiness
 More discounts availed  Less discounts availed

By Nasir Abbas FCA 8

 Ratios
4.6 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 to  Timely payment to suppliers
suppliers  Credit worthiness
 Less credit worthiness  More discounts availed
 Less discounts availed

4.7 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

Comments
Ratio result- “higher” is better

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

By Nasir Abbas FCA 9

 Ratios
4.8 Working 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

5- LONG TERM SOLVENCY / LEVERAGE RATIOS

5.1 Debt to assets ratio

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

By Nasir Abbas FCA 10

 Ratios

5.2 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.

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

5.3 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

By Nasir Abbas FCA 11