ASSIGNMENT

PRINCIPLES OF FINANCE

RATIO ANALYSIS

Name: Muhammad Kamran Ali Registration ID 021-21-54902

IU Email ID MUHAMMAD.54902@iqra.edu.pk Date of Submission Nov 05, 2021

LIQUIDITY:

Liquidity means having cash or access to cash readily available to meet obligations to make payments.

For ratio analysis, liquidity is measured on the assumption that the only sources of cash available are:

 Cash in hand or the bank, plus

 Current assets will soon be converted into cash during the normal cycle of a trade.
It is also assumed that the only immediate payment obligations faced by the entity are its current liabilities.

There are two ratios for measuring liquidity:

 Current ratio
 The quick ratio is also called the acid test ratio.
The more suitable ratio for use depends on whether inventory is considered a liquid asset that will soon be used or
sold, and converted into cash from sales.

 Current Ratio
The current ratio is the ratio of current assets to current liabilities.

Formula:

CURRENT ASSETS
CURRENT RATIO=
CURRENT LIABILITIES

The amounts of current assets and current liabilities in the statement of financial position at the end of the
year may be used. It is not necessary to use average values for the year.

 Quick Ratio or Acid Test Ratio

The quick ratio or acid test ratio is the ratio of current assets excluding inventory to current liabilities.
Inventory is excluded from current assets on the assumption that it is not a very liquid item.

Formula:

CURRENT ASSETS EXCLUDING INVENTORY

QUICK RATIO=
CURRENT LIABILITIES

The amounts of current assets and current liabilities in the statement of financial position at the end of the
year may be used. It is not necessary to use average values for the year.

PROFITABILITY:

The profit/sales ratio is the ratio of the profit that has been achieved for every Rs.1 of sales.

PROFIT
PROFIT /SALES RATIO= X 100
SALES

Profit/sales ratios are commonly used by management to assess financial performance, and a variety of different
figures for profit might be used. The definition of profit can be any of the following:

 Profit before interest and tax

 Gross profit (= Sales minus the cost of sales)
 Net profit (= Profit after tax)
It is important to be consistent in the definition of profit when comparing performance from one year to the next.

So there are 3 types of profit to sales ratio:

 Profitability/Operating profit ratio

OPERATING PROFIT
OPERATING PROFIT RATIO= X 100
SALES
 Gross profit margin ratio
GROSS PROFIT
GROSS PROFIT MARGIN RATIO= X 100
SALES
 Net profit ratio
NET PROFIT
NET PROFIT MARGIN RATIO= X 100
SALES

The gross profit ratio is often useful for comparisons between companies in the same industry or comparison with
an industry average. It is also useful to compare the net profit ratio with the gross profit ratio. A high gross profit
ratio and a low net profit ratio indicate high overhead costs for administrative expenses and selling and
distribution costs.

 Return on Equity

Return on shareholder capital (ROSC), or return on equity, measures the return on investment that the
shareholders of the company have made. This ratio normally uses the values of the shareholders’
investment as shown in the statement of financial position (rather than market values of the shares).

PROFIT AFTER TAXATION∧PREFERENCE DIVIDEND

ROSC= X 100
SHARE CAPITAL∧RESERVES

 Return on Assets

PROFIT BEFORE INTEREST ∧TAXATION

ROA= X 100
TOTAL ASSETS

The normal convention is to use ‘total assets’ which includes both current and non-current assets.
However, other variations are sometimes used such as non-current assets only.

The return on assets ratio is a profitability ratio and measures the return produced by the total assets. It
helps both, the management and the investors, to know how well the entity can convert its investment in
assets into profits. The figures of ROA depend highly on the industry and hence can vary substantially.
This suggests that when ROA has to be used as a comparative measure then the best practice is to
compare it against a company’s previous ROA figures or the ROA of a company in a similar business
line.

DEBT TO EQUITY RATIO:

Gearing, also called leverage, measures the total long-term debt of a company as a percentage of either:

 The equity capital in the company, or

 The total capital of the company
 LONG −TERM DEBT
GEARING= X 100
SHARE CAPITAL∧RESERVES

Alternatively:
LONG−TERM DEBT
GEARING= X 100
SHARE CAPITAL∧RESERVES + LONG−TERM DEBT

It is usually appropriate to use the figures from the statement of financial position at the end of the year. However,
a gearing ratio can also be calculated from average values for the year.
When there are redeemable preference shares it is usual to include them within debt capital. This is because
redeemable preference shares behave more like a long-term loan or bond with fixed annual interest followed by
future redemption.

Irredeemable preference shares behave more like Equity (as they are never redeemed) and should therefore be
treated as equity.

A company is said to be high-geared or highly leveraged when its debt capital exceeds its share capital and
reserves. This means that a company is high-geared when the gearing ratio is above either 50% or 100%,
depending on which method is used to calculate the ratio.

A company is said to be low-geared when the amount of its debt capital is less than its share capital and reserves.
This means that a company is low-geared when the gearing ratio is less than either 50% or 100%, depending on
which method is used to calculate the ratio.

A high level of gearing may indicate the following:

 The entity has a high level of debt, which means that it might be difficult for the entity to borrow more
when it needs to raise new capital.
 High gearing can indicate a risk that the entity will be unable to meet its payment obligations to lenders
when these obligations are due for payment.

The gearing ratio can be used to monitor changes in the amount of debt of a company over time. It can also be
used to make comparisons with the gearing levels of other, similar companies, to judge whether the company has
too much debt, or perhaps too little, in its capital structure.

COVERAGE RATIO:

PROFIT BEFORE INTEREST ∧TAX

INTEREST COVER RATIO= =(¿)
INTEREST EXPENSE

The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay
interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before
interest and taxes (EBIT) by its interest expense during a given period.

The interest coverage ratio is sometimes called the times interest earned (TIE) ratio. Lenders, investors, and
creditors often use this formula to determine a company's riskiness relative to its current debt or for future
borrowing.
 CALCULATION FOR THE YEAR 2000

LIQUIDITY:

 Current Ratio
CURRENT ASSETS
CURRENT RATIO=
CURRENT LIABILITIES
1,124,000
CURRENT RATIO=
481,600
CURRENT RATIO=2.33TIMES

 Quick Ratio or Acid Test Ratio

CURRENT ASSETS EXCLUDING INVENTORY
QUICK RATIO=
CURRENT LIABILITIES

408,800
QUICK RATIO=
481,600

QUICK RATIO=0.85׿
PROFITABILITY:

 Gross profit margin ratio

GROSS PROFIT
GROSS PROFIT MARGIN RATIO= X 100
SALES
3,432,000−2,864,000
PROFIT /SALES RATIO= X 100
3,432,000
PROFIT /SALES RATIO=¿16.55%
 Net profit ratio
NET PROFIT
NET PROFIT MARGIN RATIO= X 100
SALES

87,960
NET PROFIT MARGIN RATIO= X 100
3,432,000

NET PROFIT MARGIN RATIO=¿ 2.56%

DEBT TO EQUITY RATIO:

LONG −TERM DEBT

GEARING= X 100
SHARE CAPITAL∧RESERVES + LONG−TERM DEBT
323,432
GEARING= X 100
460,000+203,768+323432
GEARING=¿32.76%
RETURN ON ASSETS

PROFIT BEFORE INTEREST ∧TAXATION

ROA= X 100
TOTAL ASSETS
209,100
ROA= X 100
1,468,800

ROA=¿ 14.24% OR 0.14

COVERAGE RATIO:

PROFIT BEFORE INTEREST ∧TAX

INTEREST COVER RATIO= =(¿)
INTEREST EXPENSE

209,100
INTEREST COVER RATIO=
62,500
INTEREST COVER RATIO=¿3.35 TIMES

CALCULATION FOR THE YEAR 2001

LIQUIDITY:

 Current Ratio
CURRENT ASSETS
CURRENT RATIO=
CURRENT LIABILITIES
1,926,802
CURRENT RATIO=
1,733,760
CURRENT RATIO=1.11 TIMES

 Quick Ratio or Acid Test Ratio

CURRENT ASSETS EXCLUDING INVENTORY
QUICK RATIO=
CURRENT LIABILITIES

639,422
QUICK RATIO=
1,733,760

QUICK RATIO=0.37׿
PROFITABILITY:

 Gross profit margin ratio

 GROSS PROFIT
GROSS PROFIT MARGIN RATIO= X 100
SALES
5,834,400−5,728,000
PROFIT /SALES RATIO= X 100
5,834,400
PROFIT /SALES RATIO=¿1.82%

 Net profit ratio

NET PROFIT
NET PROFIT MARGIN RATIO= X 100
SALES

(519,936)
NET PROFIT MARGIN RATIO= X 100
5,834,400

NET PROFIT MARGIN RATIO=¿ -8.91%

DEBT TO EQUITY RATIO:

LONG −TERM DEBT

GEARING= X 100
SHARE CAPITAL∧RESERVES + LONG−TERM DEBT
1,000,000
GEARING=
460,000−327,168+1000000
GEARING=¿ 88.27%
RETURN ON ASSETS

PROFIT BEFORE INTEREST ∧TAXATION

ROA= X 100
TOTAL ASSETS
(690,560)
ROA= X 100
2,866,592

ROA=¿ -24.09% OR -0.24

COVERAGE RATIO:

PROFIT BEFORE INTEREST ∧TAX

INTEREST COVER RATIO= =(¿)
INTEREST EXPENSE

(690,560)
INTEREST COVER RATIO=
176,000
INTEREST COVER RATIO=¿ -3.92 TIMES
 For the Year 2001 For the Year 2000

Current Ratio Analysis

Current Ratio = 1.11 times Current Ratio = 2.33 times

In the year 2000, ABC company have 2.33 rupees to pay off their every 1 rupee of current liabilities but in the
year 2001, this falls to 1.11 which seems not good.
Quick Ratio Analysis
Quick Ratio = 0.37 times Quick Ratio = 0.85 times

Despite having a current ratio of about 1.11, the quick ratio is below 1.0. This means that the company may
face liquidity problems should payment of current liabilities be demanded immediately. But it does not seem to
be a huge cause for concern.
Gross Profit Margin

Gross Profit Margin = 1.82% Gross Profit Margin = 16.55%

In the year 2000, ABC have Gross profit margin of 16.55% but in the 2001 Gross profit margin falls to 1.82%
which indicates company position is not going good.
Net Profit Margin
Net Profit Margin = -8.91% Net Profit Margin = 2.56%
ABC company Net profit margin showing that company need to control their office Overhead, because
negative ratio indicates that company is making less money than it is spending.
Debt to Equity Long-term Liabilities Ratio Analysis
Debt To Equity = 88.27% Debt To Equity = 32.76%
In year 2000, company have 32.76% assets on debt and in year 2001, company have 88.27% assets on debt.
The higher ratio, the greater risk will be associated with the comapany’s operation.
Return On Assets
Return On Assets = -24.09% Return On Assets = 14.24%
In year 2000, On average every single repees invested in company’s assests generated 0.1424 paisa in profit but
in year 2001, On average every single rupee invested in company’s assets making 0.2409 paisa loss.
Coverage Ratio Analysis
Interest Coverage Ratio = -3.92 times Interest Coverage Ratio = 3.35 times
In year 2000, company have 3.35 rupees profit to pay every rupee of interest on its outstandings debts but in
year 2001, company have a 3.92 rupees shortfall in profit to pay every rupee of interest on its outstanding debs.

COMPARISION AND COMMENTS

Note: Above comparison is between the two years of the same organization and comments are totally
dependent on both year ratios but the market analysis is necessary for any final statement.