FINANCIAL RATIOS

1. INTRODUCTION TO FINANCIAL RATIOS

Financial ratios are quantitative tools used to evaluate the financial health, performance,
efficiency, and stability of an organization using its financial statements:

 Profit & Loss Statement

 Balance Sheet

 Cash Flow Statement

Objectives:
 Assess profitability

 Measure liquidity & solvency

 Evaluate operational efficiency

 Aid decision-making (investors, lenders, management)

2. CLASSIFICATION OF FINANCIAL RATIOS

Financial ratios are broadly classified into:

1. Liquidity Ratios

2. Profitability Ratios
3. Solvency (Leverage) Ratios

4. Efficiency (Activity) Ratios

5. Market Value Ratios

3. LIQUIDITY RATIOS
These measure a firm's ability to meet short-term obligations.

3.1 Current Ratio

Current Assets
Current Ratio = Current Liabilities
Meaning: Indicates the firm’s ability to pay short-term liabilities using short-term assets.
Current Assets include cash, inventory, accounts receivable, etc.

Current Liabilities include short-term debts, accounts payable, etc.

Interpretation:

 >1 → Assets exceed liabilities

 <1 → Liquidity risk

Ideal Value:
 2:1 (Standard Benchmark)

Importance of Current Ratio:

1. Measures Liquidity: It shows whether a business can meet its short-term obligations
on time.
2. Financial Stability Indicator: A higher ratio indicates better financial health, while a
very low ratio may signal liquidity problems.
3. Helps Investors & Creditors: Investors and lenders use it to assess risk before investing
or lending money.

4. Efficient Working Capital Management: It helps management maintain a balance

between assets and liabilities.

5. Ideal Ratio Insight: Generally, a ratio of 2:1 is considered satisfactory, meaning the
company has twice the assets as liabilities.

3.2 Quick Ratio (Also referred to as Acid-Test Ratio/Liquid Ratio/Near Money Ratio)

Quick Assets
Quick Ratio = OR
Quick Liabilities

Current Assets - Inventory - Prepaid Expenses

Quick Ratio =
Current Liabilities - Bank Overdraft - Pre received Income

Meaning: Measures immediate liquidity excluding inventory.

Interpretation:

 More stringent than current ratio

  Inventory may not be easily liquidated
Ideal Value:

 1:1

3.3 Cash Ratio (Also known as Absolute Liquid Ratio/Super Quick Ratio)
Cash + Cash Equivalents
Cash Ratio = Current Liabilities
Meaning: Measures the ability to pay liabilities with absolute liquid cash.

Interpretation:
 Very conservative

 Indicates emergency liquidity

Ideal Value:

 0.5:1 to 1:1

3.4 Defensive Interval Period Ratio

4. PROFITABILITY RATIOS
Measure the firm's ability to generate profits relative to sales, assets, or equity.

4.1 Gross Profit Margin

Gross Profit
Gross Profit Ratio = Net Sales
× 100
Meaning: Efficiency in production and pricing.

Interpretation:
  High → good cost control
 Low → high production cost or pricing issues

Ideal Value:

 20%–60% (industry dependent)

4.2 Operating Profit Margin

Operating Profit
Operating Profit Ratio = Net Sales
× 100
Meaning: Profit from core business operations.
Ideal Value:

 15%–30%

4.3 Net Profit Margin

Net Profit
Net Profit Ratio = Net Sales
× 100
Meaning: Overall profitability after all expenses.
Interpretation: Reflects operational + financial efficiency

Ideal Value:

 10%–20% (varies by industry)

4.4 Return on Assets (ROA)

Net Profit
ROA = × 100
Total Assets
Meaning: Efficiency in using assets to generate profit.
Interpretation:

 Higher → better asset utilization

Ideal Value:

 5%–10%

4.5 Return on Equity (ROE)

 Net Profit
ROE = × 100
Shareholders’ Equity

Meaning: Return earned by shareholders.

Interpretation:
 Higher ROE = better investment returns

Ideal Value:

 15%–25%

4.6 Return on Capital Employed (ROCE)

𝐸𝐵𝐼𝑇
ROCE = × 100
Capital Employed

5. SOLVENCY / LEVERAGE RATIOS / CAPITAL STRUCTURE RATIOS

Measure long-term financial stability and debt capacity.

5.1 Debt-Equity Ratio

Total Debt
Debt-Equity Ratio =
Shareholders’ Equity

Meaning: Proportion of debt vs equity financing.

Interpretation:

 High → risky (high leverage)

 Low → conservative
Ideal Value:

 1:1 (acceptable up to 2:1 in capital-intensive industries)

Importance of Debt-to-Equity Ratio:

1. Measures Financial Leverage: It shows the extent to which a company uses borrowed
funds.

2. Indicates Financial Risk: A high ratio means higher risk due to more debt obligations.

3. Helps Investors & Creditors: It helps in assessing the company’s long-term solvency
and risk level.
 4. Guides Capital Structure Decisions: Management uses it to maintain a proper balance
between debt and equity.
5. Impact on Profitability: Proper use of debt can increase returns, but excessive debt
can reduce profits due to high interest costs.

5.2 Debt to Capital Employed Ratio / Debt to Total Capital Ratio

5.3 Proprietary Ratio

5.4 Capital Gearing Ratio

Capital gearing ratio is calculated as (Debentures + Bonds + Loans + Preference Share

Capital) / (Equity Share Capital + Reserves and Surplus).

5.5 Interest Coverage Ratio

EBIT
ICR =
Interest Expense

Meaning: Ability to pay interest obligations.

Importance of Interest Coverage Ratio:

1. Measures Debt Servicing Ability: It shows how easily a company can pay interest on
its borrowings.
 2. Indicator of Financial Health: A higher ratio indicates strong financial stability, while a
low ratio suggests financial risk.
3. Helps Lenders and Investors: Creditors and investors use it to evaluate the company’s
risk before lending or investing.
4. Avoids Risk of Default: A low ratio may indicate difficulty in meeting interest
obligations, increasing chances of default.

5. Ideal Ratio Insight: Generally, a ratio of 2 or more is considered safe.

Interpretation:

 <1.5 → risky
 High → safe

Ideal Value:
 3 to 5 times

5.6 Debt Service Coverage Ratio (DSCR)

Net Operating Income 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥+𝑁𝑜𝑛 𝐶𝑎𝑠ℎ 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

DSCR = =
Debt Service 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Where:
 Debt Service = Principal + Interest

Meaning: Ability to meet total debt obligations.

Interpretation:

 <1 → insufficient cash

 1 → adequate coverage

Ideal Value:

 1.25 – 2.0
Importance of DSCR:

1. Measures Repayment Capacity: It shows whether the business generates enough

income to cover its total debt payments.

2. Indicator of Financial Stability: A higher DSCR indicates better financial health and
lower risk.
 3. Useful for Lenders & Banks: Banks use DSCR to decide whether to approve loans.
4. Helps in Financial Planning: It guides management in taking safe borrowing
decisions.

5. Avoids Default Risk: A low DSCR signals difficulty in repaying loans, increasing
financial risk.

Acceptable DSCR:

 DSCR = 1: Income is just enough to cover debt (risky)

 DSCR < 1: Insufficient income (unsafe)

 DSCR ≥ 1.25 to 1.50: Considered acceptable/safe by most lenders
 Higher DSCR: Indicates strong repayment capacity

5.7 Divided Coverage Ratio

This ratio talks about preference dividend and not equity dividend because preference
dividend is a fixed percentage and it is a compulsory obligation, whereas the equity dividend
is paid based on the profits earned by the company

6. EFFICIENCY / ACTIVITY RATIOS

Measure how effectively assets are used.

6.1 Inventory Turnover Ratio

Cost of Goods Sold
Inventory Turnover =
Average Inventory

Meaning: Speed of inventory movement.

Interpretation:

 High → efficient

 Low → slow-moving stock

Ideal Value:
 5–10 times (industry dependent)

6.2 Inventory Holding Period

6.3 Receivables (Debtors) Turnover Ratio

Net Credit Sales
Receivables Turnover =
Average Receivables

Meaning: Efficiency in collecting receivables.

Ideal Value:

 Higher is better (6–12 times)

6.4 Debtors Collection Period.

𝑁𝑜. 𝑜𝑓 𝐷𝑎𝑦𝑠/𝑊𝑒𝑒𝑘𝑠/𝑀𝑜𝑛𝑡ℎ𝑠 (𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟)

𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 (𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 ) =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜

6.5 Payables Turnover Ratio

Net Credit Purchases
Payables Turnover = Average Payables
Meaning: Speed of paying suppliers.
Interpretation:

 Too high → paying too quickly

 Too low → cash strain

𝑁𝑜. 𝑜𝑓 𝐷𝑎𝑦𝑠/𝑊𝑒𝑒𝑘𝑠/𝑀𝑜𝑛𝑡ℎ𝑠 (𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟)

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 (𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 ) =
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
6.4 Asset Turnover Ratio
Net Sales
Asset Turnover = Total Assets
Meaning: Revenue generated per unit of asset.
Ideal Value:
 1–2 times

7. MARKET VALUE RATIOS

Used by investors to evaluate stock performance.

7.1 Earnings Per Share (EPS)

Net Profit - Preference Dividend
EPS = No. of Equity Shares
Meaning: Profit earned per share.

7.2 Price-Earnings Ratio (P/E)

Market Price per Share
P/E Ratio = EPS
Meaning: Market expectations of growth.
Interpretation:

 High P/E → growth expectations

 Low P/E → undervalued or low growth

Ideal Value:

 15–30 (varies widely)

7.3 Dividend Yield Ratio

Dividend per Share
Dividend Yield = Market Price per Share × 100
Meaning: Return in form of dividends.