FINANCIAL RATIOS

Financial ratios are a vital tool for analyzing a company's financial operations, performance
and health. The numbers found on a company’s financial statements – balance sheet, income
statement, and cash flow statement – are used to perform quantitative analysis.
Financial ratios are grouped into the following categories:
 Liquidity ratios
 Solvency/ Leverage ratios
 Efficiency ratios/ Activity Ratios
 Profitability ratios
 Market value ratios

Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and
long-term obligations. Common liquidity ratios include the following:

 The current ratio measures a company’s ability to pay off short-term liabilities with current
assets:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

 The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick
assets:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑝𝑎𝑖𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

 The cash ratio measures a company’s ability to pay off short-term liabilities with cash and
cash equivalents:
𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝐶𝑎𝑠ℎ 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠
𝐶𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

 The operating cash flow ratio is a measure of the number of times a company can pay off
current liabilities with the cash generated in a given period:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Importance:
 Measures short-term solvency: Tells if a company can pay off short-term debts.
 Shows cash availability: Indicates how easily a company can access cash or assets to
meet immediate needs.
 Helps manage working capital: Helps businesses manage day-to-day operational
expenses like payroll and bills.
 Identifies financial risk: Low liquidity could mean the company is at risk of running
out of cash.
 Supports lending decisions: Creditors use liquidity ratios to assess whether to lend
money to a business.
Solvency/ Leverage Financial Ratios
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage
financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include
the following:

 The debt ratio measures the relative amount of a company’s assets that are provided from
debt:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

 The debt to equity ratio calculates the weight of total debt and financial liabilities against
shareholders’ equity:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

 The interest coverage ratio shows how easily a company can pay its interest expenses:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

 The debt service coverage ratio reveals how easily a company can pay its debt obligations:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝐷𝑒𝑏𝑡 𝑆𝑒𝑟𝑣𝑖𝑒𝑐 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

Importance:
 Measures long-term financial health: Tells if the company can meet its long-term
debt obligations.
 Assesses debt risk: High leverage (debt) increases financial risk, especially in
downturns.
 Shows dependence on debt: A high ratio indicates heavy reliance on borrowed money.
 Helps in strategic planning: A company with strong solvency can take on more
projects without worrying about bankruptcy.
 Guides investment decisions: Investors prefer lower leverage since it suggests lower
risk of insolvency.
Efficiency Ratios/ Activity Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a
company is utilizing its assets and resources. Common efficiency ratios include:

 The asset turnover ratio measures a company’s ability to generate sales from assets:
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

 The inventory turnover ratio measures how many times a company’s inventory is sold and
replaced over a given period:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

 The accounts receivable turnover ratio measures how many times a company can turn
receivables into cash over a given period:
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

 The days sales in inventory ratio measures the average number of days that a company
holds on to inventory before selling it to customers:
365 𝑑𝑎𝑦𝑠
𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑡𝑎𝑖𝑜

Importance:
 Measures resource usage: Shows how effectively the company uses its resources (like
inventory, assets, or receivables).
 Improves operational performance: Higher efficiency means more sales and profit
from existing assets.
 Reduces waste and inefficiencies: Helps a company spot underused resources and
improve profitability.
 Indicates cash flow health: Good efficiency ratios often correlate with better cash flow
management.
 Guides decision-making: Helps management identify areas to improve, like speeding
up inventory turnover or collecting payments faster.
Profitability Ratios
Profitability ratios measure a company’s ability to generate income relative to revenue, balance
sheet assets, operating costs, and equity. Common profitability financial ratios include the
following:

 The gross margin ratio compares the gross profit of a company to its net sales to show how
much profit a company makes after paying its cost of goods sold:
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

 The operating margin ratio, sometimes known as the return on sales ratio, compares the
operating income of a company to its net sales to determine operating efficiency:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

 The return on assets ratio measures how efficiently a company is using its assets to generate
profit:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

 The return on equity ratio measures how efficiently a company is using its equity to
generate profit:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Importance:
 Measures overall profitability: Shows how much profit the company makes from its
revenues, assets, or equity.
 Tracks business performance: Investors look for profitability ratios to gauge if the
company is efficiently turning sales into profits.
 Helps assess pricing strategies: Profit margins show if a company is pricing its
products or services well.
 Guides growth decisions: High profitability can mean more funds for expansion,
R&D, and reinvestment.
 Reflects management effectiveness: Strong profitability indicates good cost
management, pricing, and operational strategies.
Market Value Ratios
Market value ratios are used to evaluate the share price of a company’s stock. Common market
value ratios include the following:

 The book value per share ratio calculates the per-share value of a company based on the
equity available to shareholders:
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

 The dividend yield ratio measures the amount of dividends attributed to shareholders
relative to the market value per share:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜 =
𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

 The earnings per share ratio measures the amount of net income earned for each share
outstanding:
𝑁𝑒𝑡 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

 The price-earnings ratio compares a company’s share price to its earnings per share:
𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Importance:
 Shows investor expectations: The ratios reflect how the market values the company’s
future earnings and growth.
 Guides stock pricing: Helps investors determine whether a stock is under-priced or
over-priced based on expected future performance.
 Tracks investor confidence: High market value ratios usually indicate strong investor
belief in the company’s future prospects.
 Indicates market sentiment: The ratios can fluctuate with market trends, speculations,
or company news.
 Supports investment decisions: Investors use these ratios to decide whether to buy,
hold, or sell stocks.
Illustration:
Company XYZ Balance Sheet (as of December 31, 2023)

Assets Amount (in ₹)

Current Assets 3,00,00,000
- Cash and Cash Equivalents 50,00,000
- Accounts Receivable 70,00,000
- Inventory 1,00,00,000
- Prepaid Expenses 20,00,000
- Other Current Assets 60,00,000
Non-Current Assets 7,00,00,000
- Property, Plant, Equipment 5,00,00,000
- Intangible Assets 2,00,00,000
Total Assets 10,00,00,000

Liabilities and Equity Amount (in ₹)

Current Liabilities 1,50,00,000
- Short-term Debt 50,00,000
- Accounts Payable 80,00,000
- Other Current Liabilities 20,00,000
Non-Current Liabilities 2,00,00,000
- Long-term Debt 1,50,00,000
- Deferred Tax Liabilities 50,00,000
Total Liabilities 3,50,00,000
Equity 6,50,00,000
- Common Stock 4,00,00,000
- Retained Earnings 2,50,00,000
Total Liabilities & Equity 10,00,00,000

Income Statement for the Year 2023

Item Amount (in ₹)
Net Sales 8,00,00,000
Cost of Goods Sold (COGS) 4,00,00,000
Gross Profit 4,00,00,000
Operating Expenses 2,00,00,000
Operating Income (EBIT) 2,00,00,000
Interest Expenses 30,00,000
Net Income 1,20,00,000
Operating Cash Flow 1,50,00,000

Stock Market Information

Item Amount (in ₹)
Market Price per Share 250
Total Shares Outstanding 10,00,000
Dividend per Share 12