Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis

Sub Section:2Profitability Ratios
Profitability is an indicator of success in business.
Measurement of profitability is the main concern for all
interested parties, i.e. creditors, investors, owners and
management. Net sales are taken as a denominator in
calculating all the ratios for return. Gross profit margin,
operating profit margin and net profit margin represent the
companys ability to translate sales into profit at different
stages of measurement.
Gross Profit Margin(%)
This is one of the most important ratios to measure the
profitability of a company. This ratio gives the relationship
between total sales and cost of sales. Gross margin is
calculated by subtracting cost of sales from net sales. The
resultant gross profit is then divided by sales to arrive at
gross margin ratio. This ratio indicates margin available to
absorb selling and administrative costs and other expense
and losses to arrive at net profit.
=

Gross Profit
Sales

x 100

The magnitude of gross margin is largely industry specific.

Interpretation of gross margin needs reference to industry
norm.
Operating Profit Margin(%)
Operating profit is another useful indicator of profitability
resulting purely from the core operations of the business.
This ratio establishes the relationship between operational
profit and sales. The return from core operations before non
operational expenses, revenues and taxation shows the
profit generating ability of the firm from its main business.

The formula for operating profit margin is:

Operating Profit
Sales

x 100

Net Profit Margin(%)

This is the relationship between net profit and sales.
Calculation of this ratio can be modified depending on the
analyst need, such as net profit can be replaced by earning
before interest expense or earning after interest and
taxes. Analysts must look for any unusual or non-recurring
income/expenses or gain/loss that relates directly to the
core operations of the business. These items must be
excluded while measuring the pure effectiveness of the
business.
Net margin is computed using the following equation:
Net Profit
Sales

x 100

Return on Assets/Investment (ROA/ROI)(%)

This ratio measures the overall effectiveness of the business
in generating profit with the given investment/assets. The
higher this ratio, the greater the profitability. This ratio is an
indicator of overall profitability of the business with both
equity and debt capital. Investors are keen to look at this
ratio as it provides an overall picture of the business
profitability.
The equation for ROI calculation:
=

Net Profit
Total Assets

x 100

Return on Equity (ROE)(%)

Measures the return earned by the business on the owners
capital or equity capital. This ratio plays a vital role in the
equity holders investment decisions. Owners would like to
see this ratio going up. ROE is computed adopting the
formula given below:
Net Profit
Total Equity

x 100

The Dupont Analysis

The importance of ROE as an indicator of performance,
makes it desirable to divide the ratio into several
components that provide insight into the causes of the firms
ROE or any change in it. This breakdown of ROE into
component ratios is generally referred to as DuPont system.
To begin, the return on equity (ROE) ratio can be broken
down into two ratios net profit margin and equity
turnover:

ROE

Net
Income
Equity

Net Income
Net Sales

Net Sales
Equity

This reveals that ROE equals the net profit margin times the
equity turnover, which implies that a firm can improve its
return on equity by either using its equity more efficiently or
becoming more profitable.
A firms equity turnover is affected by its capital structure.
Specifically, a firm can increase its equity turnover by
employing a higher proportion of debt capital. We can see
this effect by considering the following relationship:
Net Sales

Net Sales

Total Assets

Equity

Total Assets

Equity

This equation indicates that the equity turnover ratio equals

the firms total asset turnover times the ratio of total assets
to equity, a measure of financial leverage. This break down
in equity turnover ratio implies that a firm can increase its
equity turnover either by increasing its total assets turn over
or by increasing its financial leverage ratio.
Combining these two breakdowns, we see that a firms ROE
is composed of three ratios (DuPont System) as follows:
NetIncome
CommonEqui
ty

NetIncom
e
NetSales

NetSales
x

TotalAsset
s

TotalAssets
x

CommonEqui
ty

Profit Margin x Total Assets Turnover x Financial

Leverage

Operating Expense Analysis

This analysis is done by management to assess the
effectiveness of expenses incurred in generating sales.
Operating expenses are expressed as a percentage of sales
to identify what percentage of sales is spent on a particular
overhead. For example, marketing and promotion expenses
can be expressed as a percentage of turnover; this ratio can
give some guidelines to compare the effectiveness of
marketing expenses in generating sales over a given period
of time:
=

Operating expenses
Sales

x 100

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2Liquidity Ratios

Liquidity is defined as the ability of a business to generate

cash, and liquidity ratios measure the ability to pay off
obligations as they mature. Short-term liquidity is the ratio
of
current
assets
to
current
liabilities
of
a
company. Following ratios are computed to measure shortterm liquidity:

Current Ratio
This measures the ability of a company to pay its current
liabilities such as accounts payables, short-term notes
payables etc. Current liabilities are used as denominators as
they represent most urgent debts maturing within an
operating cycle or one year which ever is longer. Current
assets, representing most liquid assets are taken as
numerator for meeting those liabilities. The current ratio
can be calculated as follows:

Current Assets
Current Liabilities

This ratio is a good barometer to measure short-term

liquidity but it has some limitations. Some items such as
prepaid expenses represent early settlement of future
liabilities and are not potential sources of cash. Similarly,
accounts receivable and inventories may not be truly
liquid. Some companies with very high current ratios may

not be able to meet their current liabilities, due to inferior

quality of accounts receivable (may be a result of loose
credit policy) or slow moving inventories which can only be
sold at discounted prices. Thus it is necessary to use some
other measure in conjunction with the current ratio such as
cash flow from operations and liquidity of other assets.

Quick Ratio
Quick Ratio or Acid test ratio is similar to the current ratio,
except it provides a more rigorous test of short-term
liquidity of the company. As mentioned earlier, prepaid
expenses, store and spares and inventory may not have
high liquidity. For this reason less liquid current assets are
excluded from the numerator.

Cash + Marketable Securities + Account Receivable

Current Liabilities

Cash Flow Per Share

Cash flow is crucial for the day-to-day running of business
activities and it is closely linked to the long-term survival of
the organization. Profitability does not guarantee cash flow,
therefore it's prudent to give due consideration to cash flow
management. Cash flow per share measures the liquid cash
and cash equivalents in a business in per share terms.

Net Income plus Non-cash Adjustments

Number of Shares Outstanding

Operating Cash Flow Ratio

This cash flow ratio measures the ability of the firm to

generate operational cash to meet current liabilities as they
fall due. Operational cash flow depends upon the nature of
the industry, and some industries generate substantial cash
flows. Therefore, conclusions should be made after referring
to industry data.

Operating Cash Flow

Current Liabilities

Cash Flow to Total Debt Ratio

This ratio indicates the cash flow available to cover total
debt obligation of the company. Banks and long-term debt
holders would be interested in this ratio as it provides
insight to the companys ability to repay the future debt
obligations.
=

Cash Flow from Operations

Total Debt

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2Financial Leverage Ratio

Companies make use of debt capital to finance their assets.

Financial leverage refers to the degree of debt capital in the
capital structure. It is believed that a certain level of debt is
desirable as it can be beneficial to the business. However,
presence of a debt element in the capital structure also
means additional financial risk (also known as bankruptcy
risk). Therefore it is important to manage the exposure to
financial risk and the following ratios are useful in identifying
this risk.

Total Debt to Total Assets

This is the first broadest test to measure the proportion of
total debt used in the capital structure to finance the assets.
The higher the ratio, the greater the financial risk. But this
phenomena is not always true, because the asset values
used to calculate this ratio are historical values, not at the
current or fair market values. Moreover, it also ignores
future potential of the business and effectiveness of the
assets. However, it gives a general idea to the analyst
regarding the amount of debt, and whether further
investigation is needed to explore reasons for abnormality in
the ratio. The ratio is computed using the following formula:

Total Debt
Total Assets

Debt to Equity
This is the ratio of total debt, both current and long-term,
and stock holders equity (net assets). This ratio analyzes
the relative proportion of all debt claims to ownership claims
against total assets, and is used as a barometer of debt
exposure.

Total Debt
Shareholders Equity

This ratio carries the same limitation as other debt ratios, as

all the amounts are derived from the balance sheet which
does not represent current fair market value nor the impact
of operational performance.

Debt to Capitalization
This is more refined version of total debt to total assets
ratio, involving only long-term portion of debt in invested
capital. Invested capital is the sum of long-term debt (LTD)
and stockholders equity.

Total Long Term Debt

Total LTD + Equity

This ratio is important in obtaining additional financing, as

usually debt covenants from existing creditors provides
certain limits to maintain this ratio. This ratio also has the
same limitations as other debt ratios.

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2Debt Service Ratio

The ability of the company to pay interest expenses is an

important aspect from the creditor or financiers point of
view. Debt service ratio facilitates measuring the
serviceability of interest expenses by an entity.

Interest Coverage
This ratio presents the relationship between income before
interest and taxes (or Earnings before interest and taxes,
EBIT) and total interest obligations. Annual earnings are the
basic source for providing debt services and must be
sufficient enough to pay off debt and interest. Changes in
this ratio might signal problems for debt servicing. The ratio
is calculated using the following formula:

Earnings before Interest & Tax/Zakat

Interest Expenses

The outcome of the ratio is expressed in number of times

the interest earned by the company.

A higher ratio indicates the ability of a company to make

interest payments from current earnings.

Fixed Financial Cost Ratio

It is necessary to consider the impact of the lease

obligations on the coverage ratio. A slight variation on the
interest coverage ratio is to recognize that firms that use
leased facilities are in essence borrowing the capital to
utilize those facilities. Higher coverage ratios suggest the
firm is better able to manage its current debt levels or that
the firm has unused borrowing capacity. These lease
payments are accounted for in the fixed financial cost ratio:

Earnings before Interest & Tax/Zakat + ELIE

Interest Expenses + ELIE

where: ELIE = estimated lease interest expense

Cash Flow Coverage of Fixed Financial Costs

A different type of variation in the coverage ratio is to use
cash flow instead of income in the numerator. The basis of
the cash flow measure is cash flow from operations (CFO)
found in the financial statements. In this form, the cash flow
measures include depreciation expense, deferred taxes, and
the impact of changes in net working capital. This version of
the ratio is defined as:

Net CFO + Interest Expense + ELIE

Interest Expenses + ELIE

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2Activity Ratios

Accounts Receivable Turnover

This is the number of times accounts receivable, on average,
are collected during a year. It also expresses the quality of
accounts receivable and the companys ability to collect
them. Generally a higher turnover ratio is good, but again it
might be indicative of overly strict credit policy.

Credit Sales
Average Receivables

Accounts Receivable Collection Period

Also called Days Sales Outstanding is the average number
of days lapsed for accounts receivable to be converted into
cash. This ratio calculates the relationship between net
accounts receivable and average daily sales.

Average Accounts Receivables

Credit Sales / 365

This ratio helps to gauge the liquidity of accounts receivable

and the ability of the company to collect them from
customers. It also provides information regarding the credit
policy and the quality of accounts receivable. For example, if
the average collection period is increasing over time, the
companys credit policy is becoming lenient and is

compromising liquidity of accounts receivables. There must

be a balance in the credit policy to avoid high bad debt and
loss of customers.

Inventory Turnover
This shows the relationship of how many times inventory
was converted into sales.

Cost of Goods Sold

Average Inventory

Generally, a high inventory turnover ratio is indicative of

aggressive sales and lower capital tied up in the inventory,
which means lower implicit financing cost. High inventory
turnover might also mean under stocking which could lead
to delay in customer orders, and ultimately loss of
customers. Higher ratio might also indicate higher sales
than expected and a shortage of inventories. On the other
hand, low inventory turnover represents weak inventory
management system, slow moving or obsolete inventory or
excess storage of inventory resulting in high carrying
costs. Similarly, low inventory turnover might stem from
further increase in demand, or shortage of raw
material. Analysts should further investigate reasons for
abnormally high or low inventory turnover.

One of the most important things to consider is the type of

industry in which the company is operating. For example, a
company which is involved in selling fresh fruits (perishable
item) has a higher turnover ratio than a company selling
furniture (non-perishable item).

Inventory Turnover in Days

This shows the ability of a firm to effectively manage
inventory. It indicates the average length of time inventory
is held by the firm. Greater inventory turnover is a sign of
active business. However, over trading i.e. large volume of
business with a small asset base could show the same
symptom.

Average Inventory
Cost of Goods Sold / 365

Payable Turnover Period

Measures average time taken by the company to settle the
creditors. This is calculated in the same manner as average
collection period:

Average Accounts Payable

Cost of Goods Sold / 365

Credits are cost free funds available to the organization and

delaying payment is desirable. However, it should not affect
the company's image and it should be noted that there could
be penalties for late payment.
Total Asset Turnover
Relates total assets to sales. This ratio measures efficiency
of the firm in utilizing the assets to generate sales. Efficient
management would make use of its assets to generate
maximum sales. However, it has to be cautioned that assets

are shown at historical cost and thus the ratio could mislead
the analyst.

Sales
Total Assets

Operating Cycle
The length of time taken from purchases of inputs to
collection of receivables resulting from sales is known as
operating cycle. This is a useful concept as it gives a basic
idea of how long it takes to turn the raw materials into cash.
A company which has a shorter operating cycle has the
capacity to turn raw materials into sales and then into cash
in a relatively shorter period and thus can operate with
minimal working capital.

Inventory Turnover in Days + Receivable Turnover in

Days

Cash Cycle
The operating cycle starts from the point of purchases of
inputs irrespective of the actual payment for such
purchases. Cash cycle is the time length between actual
outlay of cash for purchases and collection of receivables
resulting from sales. This is arrived at by subtracting the
time taken to settle the payables from the operating
cycle.

Operating Cycle Payable Turnover in Days

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2Stock Market Ratios

These ratios give an indication of how investors perceive the

company; its past performance, future prospects, etc. The
performance of the company's shares in the stock market is
crucial from shareholders point of view and management as
well. In some organizations top management bonus are
linked to the share price in the stock market.

Earnings Per Share (EPS)

Investors would like to know how much profit is generated
by each share they hold and EPS provides this valuable
information. The market fetches higher prices for high profit
growth companies. Small capitalization companies with high
profits will naturally show attractive EPS.

Net Earnings After Taxes/Zakat

Total No of Ordinary Shares Outstanding

Price Earnings Ratio

Measures the amount investors are willing to pay for
each Riyal of the firms earnings.
This ratio reflects the investors expectations concerning
the firms future prospects.

Market Price Per Share

Earnings Per Share

A PE of 10 means that the share is trading at 10 times its

earnings. Higher PE ratio shows investor optimism towards
the company and vice versa.

Earnings Yield
Measures the earnings capability of an ordinary share
relative to its market price. i.e. the return generated by each
ordinary share on its current market value. Profitable
companies carry attractive earnings yield.

Earnings Per Share

Market Price Per Share

Dividend Per Share

The amount of cash dividend calculated on a per share
basis. Investors have two modes of return from investments
namely dividend and capital gains. Dividend is regular
income while capital gains are appreciation of share price
over time. Capital gains are materialized when disposing the
shares. However, investors differ in opting for dividend or
capital gains. Some investors prefer dividend over capital
gains and some vouch for capital gains. Investors who invest
for regular income are keen to look at the dividend per
share.

Total dividend
Total No of Ordinary Shares Outstanding

A pension fund invests primarily for pensioners income and

generally invests in high dividend bearing stocks. Whereas
corporate investments are intended for capital growth in a
general sense.

Dividend Yield
Dividend return per share relative to its market value. This is
calculated in the same manner as earnings yield.

Dividend Per Share

Market Value Per Share

Dividend Pay-out Ratio

This ratio indicates what percentage is paid out as cash
dividends out of net earnings. Generally companies pursue a
dividend policy that determines the pay-out of dividends. A
high dividend pay out is a positive signal to some
shareholders, on the other hand it could also mean that the
company does not have profitable investment avenues to
make use of shareholders funds.

Dividend Per Share

Earnings Per Share

Book Value Per Share

This ratio represents the equity of the firm on a per share
basis and is sometimes used as a benchmark for comparison
with the market price per share. The focus is on how close
market value is to book value. If the stock price is very close

to book value or below book value, then the stock is a buy,

as downside risk is viewed as negligible. Thus book value is
viewed as a conservative estimate of the firms value.

Total Shareholders Equity

Total No of Ordinary Shares

Price to Book Value

Relates the market price of a share to its book value. This
ratio compares the book value of the share with the market
value to show the strength of the share i.e. what is the asset
backing, at what multiple of the book value the share is
trading in the market.

Market Price Per Share

Book Value Per Share

Price to book value of more than one means that the

investors are willing to pay higher than their accounting
book value. Well performing company shares generally trade
at multiples of its book value.

Chapter:9Fundamentals of Financial Analysis

Section :2Financial Ratio Analysis
Sub Section:2FINANCIAL RATIOS - SUMMARY

Classification

Ratios

Equation

Profitability
Ratios

Gross Profit
Margin(%)

Gross Profit X 100

Sales

Operating Profit
Margin(%)

Net Profit
Margin(%)

Return on
Investment (ROI%)

Return on Equity
(ROE%)

Definition
Measures
gross
profitability
with respect
to sales.

Operating Income X 100

Sales

Measures
operating
profitability
with respect
to sales.

Net Profit X 100

Sales

Measures
overall
profitability
with respect
to sales.

Net Profit X 100

Total Assets

Measures
the overall
effectiveness
in
generating
profits with
the given
investment.

Net Profit

X 100

Shareholder's Equity

Measures
the overall
effectiveness
in
generating
profits with
the given
equity.

Profit Margin X Total Assets- Turnover X

Financial Leverage

Measures
relationship
of other
important
ratios with
the ROE.

Current Assets
Current Liabilities

Measures
ability to
meet current
liabilities with
current
assets.

Cash+Marketable Sec.+Acc. Recv

Current Liabilities

Measures the
ability to
meet current
liabilities with
liquid current
assets.

Net Income + Non-cash Adjustments

Number of Share Outstanding

Measures the
amount of
cash
generated
from
operation per
each share.

Cash flow from Operations

Current Liabilities

Measures the
firms ability
to generate
cash from
operations to
meet current
liabilities.

Cash Flow to
Total Debt
Ratio

Cash flow from Operations

Total Debt

Measures
ability to
cover total
liabilities with
cash flow
from
operations.

Cash Flow to
Long-term
Debt

Cash flow from Operations

Long-term Debt +PV of Operating Lease

Measures
ability to
meet debt
obligation.

The Dupont
Analysis

Liquidity
Ratios

Current Ratio

Quick Ratio

Cash Flow
Per Share

Operating
Cash flow
Ratio

Cash Flow to
Interest
Bearing Debt

Financial
Leverage
Ratios

Debt to
Equity

Debt to Total
Assets

Debt to
Capitalisation

Debt
Service
Ratio

Interest
Coverage

Fixed
Financial
Cost Ratio

Cash Flow
Coverage of
Fixed
Financial
Cost

Cash flow from Operations

Long-term Debt+Current Interest
Bearing Liabilities

Measures
ability to
meet debt
obligation.

Total Debt
Shareholders Equity

Indicates the
extent of
debt
financing
relative to
equity
financing.

Total Debt
Total Assets

Indicates the
extent of
debt
financing
relative to
total assets.

Total Long-term Debt

Total Long-term Debt + Equity

Indicates the
extent of
debt
financing
relative to
capitalization.

Earnings Before Interest & Tax/Zakat

Interest Expense

Indicates the
ability to
cover interest
expenses
with the
given level of
earnings.

EarningsBeforeInterest&Tax/Zakat+ELIE
Interest Expense+ELIE

Ability to
cover interest
expenses
plus interest
on lease with
the given
level of
earnings.

CFO+Interest Expense+ELIE
Interest Expense+ELIE

Ability to
cover interest
expenses
plus interest
on lease with

given level of
CFO.

Activity
Ratios

Accounts
Receivables
Collection
Period

Inventory
Turnover

Inventory
Turnover in
Days

Accounts
Payable
Turnover
Period

Operating
Cycle

Average Accounts Receivables

Credit Sales/ 365

Measures the
number of
days taken to
collect the
receivables.

Cost of Sales
Average Inventory

Measures
number of
times the
inventory has
been turned
over into
sales.

Average Inventory
Cost of Sales/365

Measures
number of
days the
inventory is
held before
turned into
sales.

Average Accounts Payable

Credit Purchases/365

Measures
average
number of
days taken to
settle the
creditors.

Inventory Turnover + Collection Period

Measures
length of time
between the
purchase of
supplies and
collection of
cash from
receivable.

Cash Cycle

Asset
Turnover

Market
Ratios

Operating Cycle - Payable Turnover

Net Sales

Average Assets

Measures
length of time
between
actual. cashoutlay for
purchases
and collection
from
receivables.
Measures the
efficiency of
generating
sales with the
given asset
base.

Net Income
No of Ordinary Shares Outstanding

Measures
earnings
capability of
an ordinary
share

Market Price Per Share

Earnings Per Share

Measures the
amount the
investors are
willing to pay
for each
dollar of
earnings.

Earnings
Yield

Earnings Per Share

Market Price Per Share

Measures the
earnings
capability of
an ordinary
share relative
its market
value.

Dividend Per
Share

Cash Dividend
No of Ordinary Shares Outstanding

Measures the
dividend
return earned
by a share

Earnings Per
Share

Price
Earnings
Ratio - (PER)

Dividend Per Share

Market Price Per Share

Measures the
dividend
earned by a
share relative
its market
value.

Dividend
Pay-out Ratio

___Dividend Per Share__

Earnings Per Share

Indicates the
percentage of
earnings paid
out as
dividend.

Book Value
Per Share

Total Shareholders Equity

Total No. of Ordinary Shares

Measures
equity on per
share basis.

Market Price Per Share

Book Value Per Share

Measures
market price
of share
relative to
book value.

Dividend
Yield

Price to Book
Value Ratio

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