Financial Ratios

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What is a Ratio ?
• Ratio is a relationship between two or
more items of the financial statements.
E.g. Net Profit Ratio

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Ratio Analysis
• A single accounting figure by itself may
not communicate any meaningful
information but when expressed as a
relative to some other figure, it may
definitely provide some significant
information. Hence ratio analysis proves
very beneficial.

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 Ratio Analysis

• Ratio analysis is not just comparing

different numbers from financial
statements. It involves comparing the ratio
against previous years, against peers, and
with the industry average for the purpose
of financial analysis.

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 Ratio Analysis -
Advantages
Ratios help stakeholders (like owners, managers,
investors, lenders, employees) to draw
conclusion about the
Performance (past, present and future)
Strengths & weakness
And take decision in relation to the firm

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 Types of Ratio
The ratios can be classified into following
four broad categories:
1) Liquidity Ratios
2) Capital Structure/Leverage ratios
3) Profitability Ratios
4) Return Ratios

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 Ratios
1) Liquidity Ratios:
i. Current Ratio = Current Asset
Current Liabilities
where,
Current Asset (CA)= Inventories + Sundry Debtors +
Cash & Bank balances + Receivables / Accruals + Loans
& Advances + Disposable Investments

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Ratios

Current Liabilities (CL) = Creditors +

Short term Loans + Bank Overdraft +
Cash Credit +Outstanding Expenses +
Provision for Taxation + Proposed
Dividend + Unclaimed Dividend

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Ratios
Current Ratio
The main question this ratio address is:
Does business have enough current
assets to meet its current debts.

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Ratios
A generally acceptable current ratio is 1.5 to
2.
But whether or not a specific ratio is
satisfactory depends on the nature of
business and characteristics of its CA and CL.

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Ratios
ii. Quick Ratio = Quick Asset
Quick Liabilities
Quick Asset= CAs - Inventories
Quick Liabilities= CLs - Bank Overdraft

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 Ratios
• The quick ratio is a much more
conservative measure than current ratio.
• This ratio measure the immediate solvency
of the company.
• The ideal ratio is 1:1. This is irrespective of
nature of business.

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 Ratios
2) Capital Structure/Leverage Ratios:
These ratios indicate the mix of funds
provided by owners and lenders. Leverage
ratios are of two types
a) Capital Structure ratios
b) Coverage ratios

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Ratios
a) Capital Structure ratios:
These ratios provide an insight into the
financing techniques used by a business
and focus, as a consequence, on the long
term solvency position.

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Ratios
1) Equity ratio:
This ratio indicates proportion of owners
fund to total fund invested in the business.
Equity Ratio= Shareholder’s Equity
Total Capital Employed

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Ratios
2) Debt ratio:
Debt Ratio = Total Debt
Capital Employed
Total debt includes short and long term
borrowing from financial institution,
debentures/ bonds deferred payment
arrangements for buying capital equipments,
bank borrowings, public deposits and any other
interest bearing loan.
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 Ratios
• Capital employed includes total debt and
net worth.
• This ratio is used to analyse long term
solvency of the firm.

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Ratios
3) Debt equity ratio:
Debt equity Ratio=
Debt+ Preference Share Capital
Shareholders Equity

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 Ratios
• This ratio indicates the proportion of
debt fund in relation to equity. Lenders are
very keen to know this ratio since it shows
relative weight of debt and equity.
• A high ratio here means less protection
for creditors.
• A low ratio, on the other hand,
indicates a wider safety cushion.
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 Ratios
4) Profitability Ratios: Profitability ratios measure
the profitability as a percentage of sales.
a) Net Profit Ratio =
Net Profit After Tax * 100
Sales
b) Gross Profit Ratio =
Gross Profit * 100
Sales

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 Ratios
c) Operating Profit Ratio =
Operating Profit * 100
Sales

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 Ratios
5) Return Ratios:
Return ratios measure the profitability in
relation to capital used. These ratios
reflect the final results of the business.

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 Ratios
a) Return on Equity (ROE)=
Profit after Taxes * 100
Net worth
Return on equity measures the
profitability of equity funds invested in
the firm.

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 Ratios
b) Coverage ratios:
The coverage ratios measure the firm’s ability to
service the fixed liabilities. These ratios establish
the relationship between fixed claims and what is
normally available out of which these claims are
to be paid. The fixed claims of:
i) Interest on loans
ii) Preference Dividends
iii) Repayment installment of loans

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Ratios
1) Debt Service Coverage ratios=
Earnings available for debt service
Interest + Installments
Earnings for debt service= Net Profit + Non
cash operating expenses like depreciation
and other amortisation +

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Ratios
non-operating adjustments like loss on sale
of fixed assets + Interest on debt funds
Lenders are interested in debt service
coverage to judge the firms ability to pay off
current interest and instalments.

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Ratios
2) Interest Coverage ratios=EBIT
Interest
This ratio indicates the extent to which
earnings may fall without causing any
embarrassment to the company regarding
the payment of interest charges.

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Ratios
A high ratio means that an enterprise can
easily meet its interest obligation even if
EBIT suffers a considerable decline.
A lower ratio indicates excessive use of debt
or inefficient operations.

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 Ratios
3)Preference dividend Coverage ratio =
EAT
Preference dividend liability
This ratio measures the ability of a firm to
pay dividend on preference shares which
carry a stated rate of return.

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 Ratios
4) Capital Gearing ratio =
Preference Share Capital + Debenture +
Long Term Loan
Equity Share Capital + Reserves & Surplus -
Losses

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 Ratios
3) Activity Ratios:
Activity ratios are also called as Turnover
ratios or Performance ratios. These
ratios are used to evaluate efficiency
with which the company manages and
utilises its assets.

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Ratios
These ratios are usually calculated with
reference to sale/cost of goods sold and
are expressed in terms of rate or times.
Some of the important activity ratios are
as follows:

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 Ratios
a) Capital Turnover Ratio=
Sales
Capital Employed
This ratio indicates the firm’s ability of
generating sales per rupee of long term
investments.

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 Ratios
b) Fixed Asset Turnover Ratio=
Sales
Capital Asset
This ratio indicates the firm’s ability to
efficient utilisation of fixed asset in
generating sales.

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 Ratios
b) Working Capital Turnover Ratio=
Sales
Working Capital
Working Capital Turnover is further
segregated into Inventory turnover,
Debtors Turnover, Creditors turnover.

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 Ratios
i. Inventory Turnover Ratio=
Cost of Sales or Sales
Average or Closing Inventory
Average Inventory =
Opening Stock + Closing Stock
2

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Ratios
Inventory turnover ratio indicates
average stock holding period. However it
can be directly calculated as
Stock holding Period=
Average Inventory X 365/12
Sales or Cost of sales

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Ratios
This ratio indicates that how fast
inventory is sold. It establishes the
relationship between cost of goods sold
during the year and average inventory
held during the year.

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 Ratios
ii. Debtors Turnover Ratio=
Credit Sales
Average Accounts Receivables
This ratio throw light on the collection
and credit policies of the firm.

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Ratios
Debtors turnover ratio indicates average
collection period. However it can be
directly calculated as
Debtors velocity=
Average Debtors X 365/12
Credit Sales

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 Ratios
iii. Creditors Turnover Ratio=
Credit Purchase
Average Accounts Payables
This ratio shows the velocity of the debt
payment by the firm. This ratios reflect
the credit terms granted by creditors.

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Ratios
Average payment period can be
calculated as
Creditors Velocity=
Average Creditors X 365/12
Credit Purchases

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 Ratios
b) Return on capital employed (ROCE) /
Return on Investment (ROI) =
Return
Capital Employed
where ,
Return= Net Profit before Taxes +Interest
+/- Non trading adjustment

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Ratios

Capital Employed = Equity + Preference +

Reserves & Surplus + Debentures &
Other Long Term Loan – Misc.
Expenditure & Losses – Non trade
investments

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Ratios
Return on Investment (ROI) =
Profitability Ratio X Capital Turnover
Ratio
ROI can be improved either by improving
operating profit ratio or capital turnover
or by both.

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 Ratios
c) Return on Asset=
Net Profit After Tax
Average Fixed Assets
This ratio measures the profitability of
the firm in terms of assets employed in
the firm.

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 Ratios
d) Earnings per Share (EPS)=
Net Profit available to Equity
shareholders
Number of Equity Shares
The profitability per share from the
point of view equity share-holders

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 Ratios

e) Price Earning Ratio (PE)=

Market Price Per share
Earning Per Share
The PE ratio indicates the expectation of
equity investors about the earnings of
the company.

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 Ratios
f) Dividend per Share (DPS)=
Dividend distributed to Equity
shareholders
Number of Equity Shares
Dividend per share ratio indicates the
amount of profit distributed per equity
share.

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 Ratios
various ratios are good measure of:
 Growth potential of investment
 Risk characteristics
 Profitability
 Degree of liquidity
 Corporate image

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