Financial Ratio Analysis for Business Students

A set of financial statements is full of numbers, but on their own those numbers say little. Is PKR 108 million of profit good? It depends on how big the company is, how much it borrowed and how much its owners invested. Financial ratio analysis turns raw figures into comparable measures of liquidity, solvency, profitability and efficiency, and it is a core skill for BBA, B.Com, MBA, ACCA and CA students, as well as bank credit officers and investors.

The Five Families of Ratios

Ratios are usually grouped by the question they answer:

1. Liquidity: can the company pay its short-term bills?
2. Solvency (leverage): how much does it rely on debt, and can it service that debt?
3. Profitability: how much profit does it earn from sales, assets and equity?
4. Efficiency (activity): how well does it use its assets?
5. Market (investor): how does the share market value its earnings?

We will calculate the main ratios in each family for one company, then interpret them.

The Company: Indus Textiles Ltd

The following figures are for a fictional company, in PKR million.

Statement of financial position (year end):

Income statement:

• Sales revenue: 1,200
• Cost of goods sold: 840
• Gross profit: 360
• Operating expenses: 180
• Operating profit (EBIT): 180
• Interest expense: 36
• Profit before tax: 144
• Tax at 25%: 36
• Net profit: 108

The company has 20 million shares, trading at PKR 60 each, and pays a dividend of PKR 2 per share.

Worked Example 1: Calculating the Ratios

Liquidity Ratios

Current assets are \( 50 + 150 + 200 = 400 \).

$$ \text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} = \frac{400}{250} = 1.6 $$

The quick (acid-test) ratio excludes inventory, which may be slow to sell:

$$ \text{Quick ratio} = \frac{400 - 200}{250} = \frac{200}{250} = 0.8 $$

Solvency Ratios

$$ \text{Debt-to-equity} = \frac{\text{Long-term debt}}{\text{Equity}} = \frac{300}{450} = 0.67 $$

$$ \text{Interest cover} = \frac{\text{EBIT}}{\text{Interest}} = \frac{180}{36} = 5.0 \text{ times} $$

Profitability Ratios

$$ \text{Gross margin} = \frac{360}{1{,}200} = 30\%, \qquad \text{Operating margin} = \frac{180}{1{,}200} = 15\% $$

$$ \text{Net margin} = \frac{108}{1{,}200} = 9\% $$

$$ \text{Return on assets (ROA)} = \frac{108}{1{,}000} = 10.8\%, \qquad \text{Return on equity (ROE)} = \frac{108}{450} = 24\% $$

Efficiency Ratios

$$ \text{Asset turnover} = \frac{\text{Sales}}{\text{Total assets}} = \frac{1{,}200}{1{,}000} = 1.2 \text{ times} $$

$$ \text{Inventory turnover} = \frac{\text{COGS}}{\text{Inventory}} = \frac{840}{200} = 4.2 \text{ times}, \qquad \text{Inventory days} = \frac{365}{4.2} = 86.9 \text{ days} $$

$$ \text{Receivable days} = \frac{\text{Receivables}}{\text{Sales}} \times 365 = \frac{150}{1{,}200} \times 365 = 45.6 \text{ days} $$

Market Ratios

$$ \text{EPS} = \frac{\text{Net profit}}{\text{Number of shares}} = \frac{108}{20} = \text{PKR } 5.40 $$

$$ \text{P/E ratio} = \frac{\text{Share price}}{\text{EPS}} = \frac{60}{5.40} = 11.1 $$

$$ \text{Dividend payout} = \frac{2}{5.40} = 37.0\% $$

Interpreting the Results

Numbers only become meaningful through comparison, either with the company's previous years (trend analysis) or with competitors and industry averages (cross-sectional analysis). Here is how an analyst might read Indus Textiles:

• Liquidity is acceptable but depends on inventory. A current ratio of 1.6 looks comfortable, but the quick ratio of 0.8 shows that without selling stock the company could not cover its current liabilities. For a textile firm holding yarn and fabric, this is common, but a bank lender would watch it.
• Inventory is slow. Almost 87 days of inventory means cash is tied up for nearly three months. Reducing this would release cash.
• Debt is moderate and well covered. Profit covers interest five times, so a fall in profit of up to 80% would still leave interest payable from operating profit.
• Profitability is strong for owners. A 24% ROE is attractive, especially relative to a 10.8% ROA. The difference comes from the use of debt, as DuPont analysis shows.
• The market values earnings at 11 times. Whether that is cheap depends on the sector's typical P/E and the company's growth prospects.

DuPont Analysis: Why Is ROE 24%?

The DuPont identity, developed at the DuPont company in the early twentieth century, breaks ROE into three drivers:

$$ ROE = \underbrace{\frac{\text{Net profit}}{\text{Sales}}}_{\text{net margin}} \times \underbrace{\frac{\text{Sales}}{\text{Total assets}}}_{\text{asset turnover}} \times \underbrace{\frac{\text{Total assets}}{\text{Equity}}}_{\text{equity multiplier}} $$

The sales and assets cancel, leaving net profit over equity.

Worked Example 2: Comparing Two Companies with DuPont

Indus Textiles:

$$ ROE = 0.09 \times 1.2 \times \frac{1{,}000}{450} = 0.09 \times 1.2 \times 2.2222 = 0.24 = 24\% $$

A competitor, Ravi Garments, has a net margin of 6%, asset turnover of 2.0 and an equity multiplier of 1.5:

$$ ROE = 0.06 \times 2.0 \times 1.5 = 0.18 = 18\% $$

Ravi Garments uses its assets far more efficiently (turnover of 2.0 versus 1.2), but it earns thinner margins and uses less borrowing. Indus Textiles' higher ROE is driven largely by its equity multiplier of 2.22, meaning it finances more of its assets with debt and other liabilities. That boosts returns in good years but increases risk in bad ones.

This is the real value of DuPont analysis: two companies can report similar or different ROEs for very different reasons, and the decomposition tells you which lever is doing the work.

Common Mistakes in Ratio Analysis

• Mixing balance sheet and income statement timing. Strictly, ratios such as ROE should use average equity over the year; examiners usually say which to use.
• Comparing across industries. A supermarket and a cement producer have naturally different margins and turnover.
• Ignoring accounting policies. Different depreciation or inventory methods change the ratios without changing the business.
• Calculating without interpreting. Examiners and employers want to know what the ratio means and what management should do.

Ratios in Banking and Islamic Finance

Pakistani banks use liquidity, leverage and interest cover ratios when assessing loan applications. Islamic banks use the same analysis when deciding whether to provide murabaha or musharakah financing. Shariah screening of listed shares also relies on ratios, such as limits on interest-bearing debt to total assets, to decide which companies are permissible investments.

Did You Know?

• The DuPont analysis is often credited to F. Donaldson Brown, an engineer and executive at DuPont around 1914–1920, who later took the method to General Motors.
• A current ratio that is very high is not always good; it can mean idle cash or unsold stock.
• Altman's Z-score, published by Edward Altman in 1968, combines five ratios into a single score to predict corporate bankruptcy.

Key Takeaways

• Ratios fall into liquidity, solvency, profitability, efficiency and market families.
• The quick ratio is a stricter test of liquidity than the current ratio.
• ROE can be split into net margin, asset turnover and equity multiplier using DuPont analysis.
• Ratios are meaningful only when compared with past years or similar companies.
• Always interpret the numbers, not just calculate them.

Need a full ratio analysis report or help with a financial statements assignment? Amathify's experts and PhD scholars provide step-by-step solutions. Contact us on WhatsApp or through the Ask a Question form.