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Introduction to business
Ratio Analysis
ADP 1st Semester
Submitted by: Sadia Jalil
Submitted to: Prof
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Ratio
analysis is based on line items in financial statements like the balance sheet, income statement
and cash flow statement; the ratios of one item – or a combination of items - to another item
or combination are then calculated
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The trend of these ratios
over time is studied to check whether they are improving or deteriorating
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Ratio analysis is a cornerstone of fundamental analysis
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1
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Generally, the higher the value of the ratio, the larger the
margin of safety that the company possesses to cover short-term debts
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Formula to calculate current ratios:

Liquidity Ratio=

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Financial Ratio Analysis
Page 3

Acid-test or Quick Ratio:
Acid test or quick ratio measures the ability of a firm to meet its debit payments
on short notice
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Quick ratios generally consist of cash and equivalents, short term investments, and
accounts receivables
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Formula to calculate quick ratio:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Acid-test ratio=

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

2
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There are two commonly used activity ratios
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Inventory turnover=

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Receivable turnover:
If a company makes a substantial portion of its sales on credit, measuring receivables turnover
can provide useful information
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It measures how much in sales each dollar
invested in assets generates
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Profitability Ratios:
Some ratios measure the organization’s overall financial performance by evaluating
its ability to generate revenues in excess of operating costs and other expenses
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Commonly used Profitability ratios:
 Gross profit margin
 Net profit margin
 Return on equity

Gross Profit Margin:
A financial metric used to assess a firm's financial health by revealing the proportion of money
left over from revenues after accounting for the cost of goods sold
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Formula:
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡

Gross profit margin=

𝑆𝑎𝑙𝑒𝑠

Net Profit Margin:
Net profit margin is the percentage of revenue remaining after all operating expenses, interest,
taxes and preferred stock dividends (but not common stock dividends) have been deducted
from a company's total revenue
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Return on equity
measures a corporation's profitability by revealing how much profit a company generates with
the money shareholders have invested
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Leverage Ratios:




Any ratio used to calculate the financial leverage of a company to get an idea of the
company's methods of financing or to measure its ability to meet financial obligations
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A ratio used to measure a company's mix of operating costs, giving an idea of how
changes in output will affect operating income
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Commonly used leverage ratios:
 Debt ratio
 Long-term debt’ to equity

Debt Ratio:
A financial ratio that measures the extent of a company’s or consumer’s leverage
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Formula:
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Debt ratio=

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Long-term debt to equity:
The debt to equity ratio measures how much money a company should be able to borrow,
safely, over long periods of time
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Formula:
𝐿𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

Long-term debt to equity=

𝑂𝑤𝑛𝑒𝑟 ′ 𝑠𝑒𝑞𝑢𝑖𝑡𝑦

Financial Ratio Analysis
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Conclusion:
The four categories of financial ratios relates balance sheet and income statement data to one
another, help management pinpoints a firm’s strengths and weakness and indicate areas in
need of future investigation
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 In addition to calculate financial ratios managers, investors and lenders should pay close
attention to how accountants applied a number of accounting rules when preparing
financial statement
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Financial Ratio Analysis
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