Ratio Analysis

Transform raw financial data into actionable insights – the key ratios every Pakistani investor needs to evaluate stocks on the PSX.

What is Ratio Analysis?

Ratio analysis is the process of comparing different numbers from a company's financial statements to assess its performance, efficiency, liquidity, and valuation. Instead of looking at raw numbers (e.g., "Rs. 10 billion in debt"), ratios allow you to compare companies of different sizes and across industries.

Four Categories of Financial Ratios

1. Profitability Ratios – How Well Does the Company Generate Profit?

These ratios measure a company's ability to earn profits relative to sales, assets, or equity.

• Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
  Tells you how much profit remains after direct production costs. Higher is better.
• Net Profit Margin = Net Profit / Revenue
  Shows the percentage of revenue that becomes actual profit after all expenses.
• Return on Assets (ROA) = Net Profit / Total Assets
  Measures how efficiently a company uses its assets to generate profit.
• Return on Equity (ROE) = Net Profit / Shareholders' Equity
  Most watched PSX metric. Shows profit generated per rupee of shareholder investment. A high ROE (e.g., 20%+) is excellent.

PSX Example: A bank with ROE consistently above 18% is considered well-managed. Compare across banks like HBL, UBL, MCB.

2. Liquidity Ratios – Can the Company Pay Short-Term Bills?

These ratios measure the ability to meet short-term obligations (due within one year).

• Current Ratio = Current Assets / Current Liabilities
  A ratio above 1 means current assets exceed current liabilities. Above 1.5 is generally safe.
• Quick Ratio (Acid Test) = (Current Assets - Inventory) / Current Liabilities
  More stringent – excludes inventory (which may not be easily sold). A ratio below 1 can be a warning sign.

PSX Example: A textile exporter with low current ratio (0.8) might struggle during a downturn, while a cash-rich consumer goods company with ratio 2.0 is safer.

3. Leverage (Solvency) Ratios – How Much Debt Does the Company Have?

These ratios assess financial risk and long-term sustainability.

• Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity
  A ratio of 1 means equal debt and equity. Below 0.5 is low risk; above 2 is highly leveraged (risky).
• Interest Coverage Ratio = Operating Profit / Interest Expense
  Measures how easily the company can pay interest. Below 2 is concerning.

PSX Example: Cement companies often have high debt-to-equity (1.5–2.0) due to capital-intensive plants, but if interest coverage is strong, it's acceptable.

4. Valuation Ratios – Is the Stock Price Attractive?

These ratios help determine if a stock is overpriced or undervalued relative to its earnings, sales, or book value.

• Price-to-Earnings (P/E) Ratio = Share Price / Earnings Per Share (EPS)
  The most famous ratio. A high P/E (e.g., 20+) implies high growth expectations; a low P/E (e.g., 5) may indicate undervaluation or problems.
• Price-to-Book (P/B) Ratio = Share Price / Book Value Per Share
  Compares market price to accounting net asset value. P/B below 1 may indicate the stock is trading below its liquidation value.
• Dividend Yield = Annual Dividend Per Share / Share Price
  Shows return from dividends. PSX dividend yields typically range from 4% to 9%.

PSX Example: A bank trading at P/B of 0.8 might be undervalued; a tech stock with P/E of 30 could be overvalued unless growth justifies it.

Quick Reference Table

How to Use Ratio Analysis for PSX Stock Picking

1. Compare within the same industry. A cement company's debt-to-equity cannot be compared to a software firm's – industry averages differ.
2. Look at trends over time. Improving ROE over 3-5 years is a strong sign.
3. Benchmark against the market. The PSX average P/E ratio is usually between 6 and 9. A stock with P/E of 12 may be overvalued unless it has exceptional growth.
4. Combine multiple ratios. A low P/E with high debt-to-equity may still be risky.

For real-time ratio data, visit websites like SCtrade, Investo.pk, or your broker's research portal.