HomeChapter 8: Ratio Analysis and Interpretation

Chapter 8: Ratio Analysis and Interpretation

8.1 Liquidity Ratios

Liquidity ratios measure the group’s ability to meet short-term obligations:

  • Current ratio = Current assets ÷ Current liabilities
  • Quick ratio = (Current assets – Inventory) ÷ Current liabilities
Current ratio = 6 530 ÷ 2 973 = 2.20×  
Quick ratio   = (6 530 – 2 170) ÷ 2 973 = 1.45×

8.2 Profitability Ratios

Profitability ratios show how efficiently the group generates profit:

  • Gross profit margin = Gross profit ÷ Revenue
  • Return on equity (ROE) = Profit for the year ÷ Average equity
  • Return on assets (ROA) = Profit for the year ÷ Average total assets
Gross profit margin = 5 900 ÷ 14 300 = 41.3%  
ROE                 = 3 057 ÷ ((12 100 + 13 957)/2) = 23.5%  
ROA                 = 3 057 ÷ ((18 100 + 21 730)/2) = 15.5%

8.3 Leverage Ratios

Leverage ratios assess the group’s use of debt financing:

  • Debt to equity = Total liabilities ÷ Total equity
  • Interest cover = Operating profit ÷ Finance costs
Debt to equity = 5 013 ÷ 16 732 = 0.30 (30.0%)  
Interest cover = 4 090 ÷  —  = —×  (if finance costs = zero, cover is high)

8.4 Market Ratios

Market ratios indicate returns relative to market metrics:

  • Earnings per share (EPS) = Profit for the year ÷ Shares outstanding
  • Price to earnings (P/E) = Market price per share ÷ EPS
EPS = 3 057 000 ÷ 20 000 000 = \$0.153  
P/E = [Market price, e.g. \$2.50] ÷ 0.153 = 16.34×

8.5 Interpreting Trends and Benchmarking

– A current ratio above 1.5×–2.0× suggests strong liquidity; too high may signal under-utilized assets.
– Gross margin trends reveal cost control or pricing power shifts.
– Declining ROE or ROA may indicate capital growth outpacing profit growth.
– Debt to equity below 50% signals conservative financing; benchmark against peers.
– P/E compared to industry averages highlights market expectations.

8.6 Sample Calculations & Commentary

2024 vs 2025 Current Ratio
2024: 2.20× → ample cover of current liabilities
2025: 2.85× → improved liquidity, but monitor working capital deployment.

8.7 Practice Problems

  1. Calculate the quick ratio if current assets are \$8 000,000 (including inventory \$2 500,000) and current liabilities are \$3 000,000.
  2. Given profit for the year of \$2,400,000, average equity of \$12,000,000, calculate ROE.
  3. Compute debt to equity if total liabilities are \$4,500,000 and equity is \$15,000,000.
  4. With EPS of \$0.20 and a share price of \$3.00, determine the P/E ratio and comment on whether this suggests high growth expectations.

8.7 Strategic Approach: Ratio Analysis and Interpretation

Follow this structured method to calculate, benchmark and interpret key financial ratios:

  1. Gather Consolidated Data
    Extract the required line items from the consolidated statements:
    • Current assets & liabilities
    • Inventory, receivables, cash
    • Revenue, cost of sales, gross profit, operating profit, net profit
    • Total assets & equity (beginning & ending)
    • Finance costs and shares outstanding
    • Market price per share (for P/E ratio)
  2. Define Ratio Categories
    Decide which ratios you need:
    • Liquidity: Current ratio, Quick ratio
    • Profitability: Gross profit margin, Net profit margin, ROE, ROA
    • Leverage: Debt to equity, Interest cover
    • Market: EPS, P/E
  3. Compute Each Ratio
    Use precise formulas : Current ratio: Current ratio = Current assets Current liabilities Quick ratio: Quick ratio = Current assets − Inventory Current liabilities Gross profit margin: Gross profit margin = Gross profit Revenue Return on equity (ROE): ROE = Profit for the year Equity_opening + Equity_closing 2 Debt to equity: Debt to equity = Total liabilities Total equity Earnings per share (EPS): EPS = Profit for the year Shares outstanding Price/Earnings (P/E) ratio: P/E = Market price per share EPS
  4. Benchmark & Trend Analysis
    Compare each ratio:
    • Across periods (year-over-year)
    • Against industry peers or benchmarks
  5. Interpret Results
    For each ratio, ask:
    • What does the level/trend say about liquidity, profitability, leverage or market expectations?
    • Are there any red flags or strengths?
  6. Document Assumptions
    Note in your analysis:
    • Shares outstanding used for EPS
    • Average equity / assets calculation method
    • Market price date for P/E
  7. Present Findings Clearly
    Use tables and charts to display ratios, then provide concise narrative commentary.
  8. Validate & Review
    Ensure:
    • Calculations tie to the financial statements
    • Rounding is consistent
    • Interpretations are logical and supported by data