Ratio Analysis

Ratio Analysis

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Ratio analysis evaluates financial statements by expressing relationships between line items in PKR or as percentages, classified into four ACCA/CA Pakistan categories: profitability, liquidity, efficiency (activity), and gearing (solvency). Each category answers a distinct stakeholder question about returns, short-term survival, asset utilisation, and long-term risk.

• Current ratio = Current assets ÷ Current liabilities (times)
• Quick (acid test) ratio = (Current assets − Inventory) ÷ Current liabilities (times)
• ROCE = Profit before interest and tax (PBIT) ÷ Capital employed × 100 (%)
• Gross profit margin = Gross profit ÷ Revenue × 100 (%)

High-yield exam pointers

• Always state the formula and suffix the unit (%, times).
• Use PBIT, not profit after tax, for ROCE and interest cover.
• Three sentences per paragraph, two-decimal accuracy.

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

The four ratio categories

Category	Key question	Example ratio
Profitability	How much return on sales/capital?	Net profit margin, ROCE
Liquidity	Can short-term debts be met?	Current ratio, Quick ratio
Efficiency (activity)	How well are assets used?	Inventory turnover, Receivables days
Gearing (solvency)	What is the long-term debt burden?	Gearing ratio, Interest cover

Mechanism and formula derivations

The current ratio divides current assets by current liabilities to test whether stock, debtors and cash together cover obligations due within twelve months. The quick ratio strips out inventory because it is the least liquid current asset and in most keys the slowest to convert into cash.

ROCE uses PBIT rather than profit after tax because PBIT is independent of financing structure and tax jurisdiction, making returns comparable across firms with different debt mixes or tax rates. Capital employed is in standard papers defined as total equity plus non-current liabilities, and the chosen definition must be applied consistently throughout a single piece of analysis.

Inventory turnover divides cost of sales by average inventory rather than closing inventory to smooth seasonal fluctuations and year-end stockbuild distortions, giving a more representative measure of stock movement.

Common traps examiners exploit

• Using profit after tax instead of PBIT for ROCE or interest cover.
• Switching capital employed definitions mid-answer.
• Comparing ratios across firms with different year-ends or accounting policies.
• Forgetting that the quick ratio includes receivables and prepayments, not just cash.

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Limitations and context

Ratios are built on historical cost statements, so they ignore changing price levels and the effect of inflation on asset values. A single ratio rarely gives a complete picture because accruals and timing differences distort numerators and denominators. Two firms with identical current ratios can have very different liquidity profiles if one holds slow-moving stock and the other holds readily saleable receivables.

Worked micro-example

A summary statement shows: Revenue PKR 800,000; Gross profit PKR 320,000; PBIT PKR 120,000; Current assets PKR 250,000 (including inventory PKR 90,000); Current liabilities PKR 125,000; Capital employed PKR 600,000.

• Gross profit margin = 320,000 ÷ 800,000 × 100 = 40.00%
• Current ratio = 250,000 ÷ 125,000 = 2.00 times
• Quick ratio = (250,000 − 90,000) ÷ 125,000 = 1.28 times
• ROCE = 120,000 ÷ 600,000 × 100 = 20.00%

Trend vs. inter-firm analysis

Approach	What it shows	Typical use
Horizontal (trend)	Direction of change over 2–5 years	Internal performance review
Vertical (peer)	Position vs. industry average	Credit and investment analysis

Practice prompts

1. Compute the current ratio, quick ratio, and ROCE from a given trial balance, stating formulas and units.
2. Comment in two to three sentences on whether a falling gross margin but rising inventory turnover signals improved or worsening efficiency.

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