Academy R AT I O A N A L Y S I S

DEFINITION
and as the
ica ted qu o ent of tw o mathema cal expressions
ind ra o
A ra o is defined as “the s.” He re ra o me an s fin ancial ra o or accoun ng
or more thing
rela onship between two rel a onship between two acco
un ng figures.
cal ex pre ssi on of the
which is a mathema

RATIO ANALYSIS
The term financial ra o can be explained by defining how it is calculated and what the objec ve of this
calcula on is
a. Calcula on Basis (Basis of Calcula on)
Ø A rela onship expressed in mathema cal terms;
Ø Between two individual figures or group of figures;
Ø Connected with each other in some logical manner; and
Ø Selected from financial statements of the concern

b. Objec ve for financial ra os is that all stakeholders (owners, investors, lenders, employees etc.) can
draw conclusions about the
Ø Performance (past, present and future);
Ø Strengths & weaknesses of a firm; and
Ø Can take decisions in rela on to the firm.

Ra o analysis is based on the fact that a single accoun ng figure by itself may not communicate any
meaningful informa on but when expressed rela ve to some other figure, it may definitely provide some
significant informa on.

Ra o analysis is not just comparing different numbers from the balance sheet, income statement, and cash
flow statement. It is comparing the number against previous years (intra-firm comparison) and, other
companies (inter-firm comparison), the industry, or even the economy in general for the purpose of financial
analysis.

Sources of Financial Data for Analysis

The sources of informa on for financial statement analysis are:

1. Annual Reports 4. Statement of cash flows

2. Interim financial statements 5. Business periodicals

3. Notes to Accounts 6. Credit and investment advisory services

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Types of Ra os

Ac vity Ra os/
Efficiency Ra os/
Performance
Leverage Ra os/ Ra os/ Turnover Ra os*
Long term Solvency
Ra os

Capitel Structure Ra os Profitability Ra os

Coverage Ra os
Related to Sales

Required for analysis

Liquidity Ra os/ from Owner's point of
Short-term Solvency view
Ra os
Related to overall Return
on lnvertment (Assets/
Capital Employed/ Equity)

Related to Market/
Valua on/ Investors

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CLASSIFICATION OF RATIOS

1. LIQUIDITY RATIOS

The terms 'liquidity' and 'short-term solvency' are used synonymously.

Liquidity or short-term solvency means ability of the business to pay its short-term liabili es. Inability to pay-
off short-term liabili es affects its credibility as well as its credit ra ng. Con nuous default on the part of the
business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and
dissolu on. Short-term lenders and creditors of a business are very much interested to know its state of
liquidity because of their financial stake. Both lack of sufficient liquidity and excess liquidity is bad for the
organiza on.
Various Liquidity Ra os are:
(a) Current Ra o
(b) Quick Ra o or Acid test Ra o
(c) Cash Ra o or Absolute Liquidity Ra o
(d) Basic Defense Interval or Interval Measure Ra os
(e) Net Working Capital Ra o

(a) Current Ra o: The Current Ra o is one of the best known measures of short-term solvency. It is the most
common measure of short-term liquidity.

The main ques on this ra o addresses is: "Does your business have enough current assets to meet the
payment schedule of its current debts with a margin of safety for possible losses in current assets?" In
other words, current ra o measures whether a firm has enough resources to meet its current
obliga ons.

Where,
Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals +
Loans and Advances + Disposable Investments + Any other current assets.
Current Liabili es = Creditors for goods and services + Short-term Loans + Bank Overdra + Cash
Credit + Outstanding Expenses + Provision for Taxa on + Proposed Dividend +
Unclaimed Dividend + Any other current liabili es.

Interpreta on
A generally acceptable current ra o is 2:1. But whether or not a specific ra o is sa sfactory depends on
the nature of the business and the characteris cs of its current assets and liabili es.

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(b) Quick Ra o: The Quick Ra o is some mes called the "acid-test" ra o and is one of the best measures of
liquidity.

Where,
Quick Assets = Current Assets − Inventories − Prepaid expenses
Current Liabili es = As men oned under Current Ra o.

The Quick Ra o is a much more conserva ve measure of short-term liquidity than the Current Ra o. It
helps answer the ques on: "If all sales revenues should disappear, could my business meet its current
obliga ons with the readily conver ble quick funds on hand?"
Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on
the belief that these are not 'near cash assets' and also because in mes of financial difficulty, inventory
may be saleable only at liquida on value. But in a seller's market, inventories are also near cash assets.

Interpreta on
An acid-test of 1:1 is considered sa sfactory unless the majority of "quick assets" are in accounts
receivable, and the pa ern of accounts receivable collec on lags behind the schedule for paying current
liabili es.

(c) Cash Ra o/ Absolute Liquidity Ra o: The cash ra o measures the absolute liquidity of the business.
This ra o considers only the absolute liquidity available with the firm. This ra o is calculated as:

Interpreta on
The Absolute Liquidity Ra o only tests short-term liquidity in terms of cash and marketable securi es/
current investments.

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(d) Basic Defense Interval/ Interval Measure:

Interpreta on
If for some reason all the company's revenues were to suddenly cease, the Basic Defense Interval would
help determine the number of days for which the company can cover its cash expenses without the aid of
addi onal financing.

(e) Net Working Capital Ra o: Net working capital is more a measure of cash flow than a ra o. The result of
this calcula on must be a posi ve number. However, in certain business models it may be nega ve. It is
calculated as shown below:

Net Working Capital Ra o = Current Assets - Current Liabili es (Excluding short-term bank borrowing)

Interpreta on
Bankers look at Net Working Capital over me to determine a company's ability to weather financial
crises. Loans are o en ed to minimum working capital requirements.

2. LONG-TERM SOLVENCY RATIOS /LEVERAGE RATIOS

The leverage ra os may be defined as those financial ra os which measure the long-term stability and capital
structure of the firm. These ra os indicate the mix of funds provided by owners and lenders and assure the
lenders of the long term funds with regard to:
ü Periodic payment of interest during the period of the loan and
ü Repayment of principal amount on maturity.

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Leverage ra os are of two types:

Capital
Coverage
Structure
Ra os
Ra os

(a) Equity Ra o (a) Debt-Service Coverage Ra o (DSCR)

(b) Debt Ra o (b) Interest Coverage Ra o
(c) Debt to Equity Ra o (c) Preference Dividend Coverage Ra o
(d) Debt to Total Assets Ra o (d) Fixed Charges Coverage Ra o
(e) Capital Gearing Ra o
(f) Proprietary Ra o

(i) Capital Structure Ra os

These ra os provide an insight into the financing techniques used by a business and focus, as a
consequence, on the long-term solvency posi on.

From the balance sheet one can get only the absolute fund employed and its sources, but only capital
structure ra os show the rela ve weight of different sources.
Various capital structure ra os are:
(a) Equity Ra o:

This ra o indicates propor on of owners' fund to total fund invested in the business. Tradi onally,
it is believed that higher the propor on of owners' fund lower is the degree of risk for poten al
lenders.
(b) Debt Ra o:

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Total debt or total outside liabili es includes short and long-term borrowings from financial
ins tu ons, debentures/bonds, deferred payment arrangements for buying capital equipment,
bank borrowings, public deposits and any other interest bearing loan.

Interpreta on
This ra o is used to analyse the long-term solvency of a firm. A ra o greater than 1 would mean
greater por on of company assets are funded by debt and could be a risky scenario.

(c) Debt to Equity Ra o:

*Not merely long-term debt i.e. both current & non-current liabili es.
** Some mes only interest-bearing, long term debt is used instead of total liabili es (exclusive of
current liabili es)
The shareholders' equity is equity and preference share capital + post accumulated profits
(excluding fic ous assets etc).

Interpreta on
A high debt to equity ra o here means less protec on for creditors, a low ra o, on the other hand,
indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible
losses of income and capital). This ra o indicates the propor on of debt fund in rela on to equity.
This ra o is very o en used for making capital structure decisions such as issue of shares and/ or
debentures. Lenders are also very keen to know this ra o since it shows rela ve weights of debt
and equity. Debt equity ra o is the indicator of firm's financial leverage.

(d) Debt to Total Assets Ra o: This ra o measures the propor on of total assets financed with debt
and, therefore, the extent of financial leverage.

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Higher the ra o, indicates that assets are less backed up by enquity and hence higher the financial
leverage.
(e) Capital Gearing Ra o: In addi on to debt-equity ra o, some mes capital gearing ra o is also
calculated to show the propor on of fixed interest (dividend) bearing capital to funds belonging to
equity shareholders i.e. equity funds or net worth. Again, higher ra o may indicate more risk.

(f) Proprietary Ra o:

Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve & Surplus. Total
assets exclude fic ous assets and losses.

Interpreta on
It indicates the propor on of total assets financed by shareholders. Higher the ra o, less risky
scenario it shall be.

(ii) Coverage Ra os
The coverage ra os measure the firm's ability to service the fixed liabili es. These ra os establish the
rela onship between fixed claims and what is normally available out of which these claims are to be paid.
The fixed claims consist of:
(i) Interest on loans
(ii) Preference dividend
(iii) Amor sa on of principal or repayment of the instalment of loans or redemp on of preference
capital on maturity.

The following are important coverage ra os:

(a) Debt Service Coverage Ra o (DSCR): Lenders are interested in debt service coverage to judge the firm's
ability to pay off current interest and instalments.

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Earning for debt service* = Net profit (Earning a er taxes) + Non-cash opera ng expenses like
deprecia on and other amor za ons + Interest + other adjustments like loss
on sale of Fixed Asset etc.

*Fund from opera ons (or cash from opera ons) before interest and taxes also can be considered as per
the requirement.

Interpreta on
Normally DSCR of 1.5 to 2 is sa sfactory. You may note that some mes in both numerator and
denominator lease rentals may also be added.
(b) Interest Coverage Ra o: This ra o also known as “ mes interest earned ra o” indicates the firm's ability
to meet interest (and other fixed-charges) obliga ons. This ra o is computed as:

Interpreta on
Earnings before interest and taxes are used in the numerator of this ra o because the ability to pay
interest is not affected by tax burden as interest on debt funds is deduc ble expense. It measures how
many mes a company can cover its current interest payment with its available earnings. In other words,
it reflects the margin of safety a company has for paying interest on its debt during a given period. A high
interest coverage ra o means that an enterprise can easily meet its interest obliga ons even if earnings
before interest and taxes suffer a considerable decline. A lower ra o indicates excessive use of debt or
inefficient opera ons.

(c) Preference Dividend Coverage Ra o: This ra o measures the ability of a firm to pay dividend on
preference shares which carry a stated rate of return. This ra o is computed as:

Earnings a er tax is considered because unlike debt on which interest is charged on the profit of the firm,
the preference dividend is treated as appropria on of profit.

Interpreta on
This ra o indicates margin of safety available to the preference shareholders. A higher ra o is desirable
from preference shareholders point of view..

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Similarly, Equity Dividend coverage ra o can also be calculated taking (EAT – Pref. Dividend) and equity
fund figures into considera on.

(d) Fixed Charges Coverage Ra o: This ra o shows how many mes the cash flow before interest and taxes
covers all fixed financing charges. This ra o of more than 1 is considered as safe.

Notes for calcula ng Ra os:

1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes)
EAT (Earnings a er taxes) = PAT (Profit a er taxes),
EBT (Earnings before taxes) = PBT (Profit before taxes)
2. Ra os shall be calculated based on requirement and availability of informa on and may deviate from
original formulae. If required, assump ons should be given.
3. Numerator should be taken in correspondence with the denominator and vice-versa.
3. ACTIVITY RATIOS/ EFFICIENCY RATIOS/ PERFORMANCE RATIOS/ TURNOVER RATIOS
These ra os are employed to evaluate the efficiency with which the firm manages and u lises its assets. For
this reason, they are o en called 'Asset management ra os'. These ra os usually indicate the frequency of
sales with respect to its assets. These assets may be capital assets or working capital or average inventory.

Ac vity Ra os/ Efficiency Ra os/ Performance Ra os/ Turnover Ra os:

(a) Total Assets Turnover Ra o
(b) Fixed Assets Turnover Ra o
(c) Capital Turnover Ra o
(d) Current Assets Turnover Ra o
(e) Working Capital Turnover Ra o
(i) Inventory/ Stock Turnover Ra o
(ii) Receivables (Debtors) Turnover Ra o
(iii) Payables (Creditors) Turnover Ra o.

These ra os are usually calculated with reference to sales/cost of goods sold and are expressed in terms of rate
or mes.

Asset Turnover Ra os: Based on different concepts of assets employed, it can be expressed as follows:

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(a) Total Asset Turnover Ra o: This ra o measures the efficiency with which the firm uses its total assets.
Higher the ra o, be er it is. This ra o is computed as:

(b) Fixed Assets Turnover Ra o: It measures the efficiency with which the firm uses its fixed assets.

Interpreta on
A high fixed assets turnover ra o indicates efficient u lisa on of fixed assets in genera ng sales. A firm
whose plant and machinery are old may show a higher fixed assets turnover ra o than the firm which has
purchased them recently.

(c) Capital Turnover Ra o/ Net Asset Turnover Ra o:

Interpreta on
This ra o indicates the firm's ability of genera ng sales/ Cost of Goods Sold per rupee of long-term
investment. The higher the ra o, the more efficient is the u lisa on of owner's and long-term creditors'
funds. Net Assets includes Net Fixed Assets and Net Current Assets (Current Assets – Current Liabili es).
Since Net Assets equals to capital employed it is also known as Capital Turnover Ra o.

(d) Current Assets Turnover Ra o: It measures the efficiency using the current assets by the firm.

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(e) Working Capital Turnover Ra o:

Interpreta on
Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors
Turnover.

Note: Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital also can be
taken in the denominator for the above ra os.

(i) Inventory/ Stock Turnover Ra o: This ra o also known as stock turnover ra o establishes the
rela onship between the cost of goods sold during the year and average inventory held during
the year. It measures the efficiency with which a firm u lizes or manages its inventory. It is
calculated as follows:

Opening Stock + Closing Stock

*Average Inventory =
2
In the case of inventory of raw material, the inventory turnover ra o is calculated using the
following formula:
Raw Material Consumed
Raw Material Inventory Turnover Ratio =
Average Raw Material Stock
Interpreta on
This ra o indicates that how fast inventory is used or sold. A high ra o is good from the view point
of liquidity and vice versa. A low ra o would indicate that inventory is not used/ sold/ lost and stays
in a shelf or in the warehouse for a long me.
(ii) Receivables (Debtors) Turnover Ra o: In case firm sells goods on credit, the realiza on of sales
revenue is delayed and the receivables are created. The cash is realised from these receivables later
on.

The speed with which these receivables are collected affects the liquidity posi on of the firm. The
debtor's turnover ra o throws light on the collec on and credit policies of the firm. It measures the
efficiency with which management is managing its accounts receivables. It is calculated as follows:

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A low debtors' turnover ra o reflects liberal credit terms granted to customers, while a high ra o
shows that collec ons are made rapidly.

Receivables (Debtors') Velocity: Debtors' turnover ra o indicates the average collec on period.
However, the average collec on period can be directly calculated as follows:
Average Accounts Receivables
Receivable Velocity / Average Collection Period =
Average Daily Credit Sales
12 months / 52 weeks / 360 days
Or, =
Receivable Turnover Ratio

Credit Sales
Average Daily Credit Sales =
No. of days in a year (say 360)

Interpreta on
The average collec on period measures the average number of days it takes to collect an account
receivable. This ra o is also referred to as the number of days of receivable and the number of day's
sales in receivables.

(iii) Payables Turnover Ra o: This ra o is calculated on the same lines as receivable turnover ra o is
calculated. This ra o shows the velocity of payables payment by the firm. It is calculated as follows:

A low creditor's turnover ra o reflects liberal credit terms granted by suppliers, while a high ra o
shows that accounts are se led rapidly.

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Payable Velocity / Average payment period can be calculated using:

In determining the credit policy, debtor's turnover and average collec on period provide a unique
guidance.

Interpreta on
The firm can compare what credit period it receives from the suppliers and what it offers to the
customers. Also, it can compare the average credit period offered to the customers in the industry
to which it belongs.

The above three ra os i.e. Inventory Turnover Ra o/ Receivables Turnover Ra o are also relevant
to examine liquidity of an organiza on.

Notes for calcula ng Ra os:

1. Only selling & distribu on expenses differen ate Cost of Goods Sold (COGS) and Cost of Sales
(COS) in its absence, COGS will be equal to sales.
2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ra os elimina ng
profit part.
3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital/ also can
be taken in denominator while calcula ng the above ra os. In fact, when average figures of
total assets, net assets, capital employed, shareholders' fund etc. are available it may be
preferred to calculate ra os by using this informa on.
4. Ra os shall be calculated based on requirement and availability of informa on and may
deviate from original formulae. If required, assump ons should be given.

4. PROFITABILITY RATIOS
The profitability ra os measure the profitability or the opera onal efficiency of the firm. These ra os reflect
the final results of business opera ons. They are some of the most closely watched and widely quoted ra os.
Management a empts to maximize these ra os to maximize the firm's value.

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The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales
or owner's interest etc. Therefore, the profitability ra os are broadly classified in four categories:
(i) Profitability Ra os related to Sales
(ii) Profitability Ra os related to Overall Return on Investment
(iii) Profitability Ra os required for Analysis from Owner's Point of View
(iv) Profitability Ra os related to Market/ Valua on / Investors.
Profitability Ra os are as follows:
(i) Profitability Ra os based on Sales
(a) Gross Profit Ra o
(b) Net Profit Ra o
(c) Opera ng Profit Ra o
(d) Expenses Ra o

(ii) Profitability Ra os related to Overall Return on Assets / Investments

(a) Return on Investments (ROI)
(i) Return on Assets (ROA)
(ii) Return of Capital Employed (ROCE)
(iii) Return on Equity (ROE)

(iii) Profitability Ra os required for Analysis from Owner's Point of View

(a) Earnings per Share (EPS)
(b) Dividend per Share (DPS)
(c) Dividend Pay-out Ra o (DP)

(iv) Profitability Ra os related to Market/ Valua on/ Investors

(a) Price Earnings (P/E) Ra o
(b) Dividend and Earning Yield
(c) Market Value/ Book Value per Share (MVBV)
(d) Q Ra o

(i) Profitability Ra os based on Sales

(a) Gross Profit (G.P) Ra o/ Gross Profit Margin: It measures the percentage of each sale in rupees
remaining a er payment for the goods sold.

Interpreta on
Gross profit margin depends on the rela onship between sales price, volume and costs. A high Gross
Profit Margin is a favourable sign of good management.

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(b) Net Profit Ra o/ Net Profit Margin: It measures the rela onship between net profit and sales of the
business. Depending on the concept of net profit it can be calculated as:

Interpreta on
Net Profit ra o finds the propor on of revenue that finds its way into profits a er mee ng all expenses. A
high net profit ra o indicates posi ve returns from the business.

(c) Opera ng Profit Ra o: Opera ng profit ra o is also calculated to evaluate opera ng performance of
business.

Where,
Opera ng Profit = Sales – Cost of Goods Sold (COGS) – Expenses

Interpreta on
Opera ng profit ra o measures the percentage of each sale in rupees that remains a er the payment
of all costs and expenses except for interest and taxes. This ra o is followed closely by analysts because
it focuses on opera ng results. Opera ng profit is o en referred to as earnings before interest and taxes
or EBIT.

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(d) Expenses Ra o: Based on different concepts of expenses it can be expressed in different variants as
below:

Administra on Expenses Ra o and Selling & Distribu on Expenses Ra o can also be calculated in
similar ways.

(ii) Profitability Ra os related to Overall Return on Assets/ Investments

(a) Return on Investment (ROI): ROI is the most important ra o of all. It is the percentage of return on funds
invested in the business by its owners. In short, this ra o tells the owner whether or not all the effort put
into the business has been worthwhile. It compares earnings/ returns/ profit with the investment in the
company. The ROI is calculated as follows:

So, ROI = Profitability Ra o × Investment Turnover Ra o. ROI can be improved either by improving
Profitability Ra o or Investment Turnover Ra o or by both.

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The concept of investment varies and accordingly there are three broad categories of ROI i.e.
(i) Return on Assets (ROA),
(ii) Return on Capital Employed (ROCE) and
(iii) Return on Equity (ROE).

We should keep in mind that investment may be Total Assets or Net Assets. Further, funds employed in
net assets are also known as capital employed which is nothing but Net worth plus Debt, where Net
worth is equity shareholders' fund. Similarly, the concept of returns/ earnings/ profits may vary as per
the requirement and availability of informa on.

(i) Return on Assets (ROA): The profitability ra o is measured in terms of rela onship between net profits
and assets employed to earn that profit. This ra o measures the profitability of the firm in terms of
assets employed in the firm. Based on various concepts of net profit (return) and assets the ROA may be
measured as follows:

Here net profit is exclusive of interest. As Assets are also financed by lenders, hence ROA can be
calculated as:

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(ii) Return on Capital Employed (ROCE): It is another varia on of ROI. The ROCE is calculated as follows:

Where,
Capital Employed = Total Assets – Current Liabili es
Or
= Fixed Assets + Working Capital
Or
= Equity + Long Term Debt

ROCE should always be higher than the rate at which the company borrows.
Intangible assets (assets which have no physical existence like goodwill, patents and trade-marks) should
be included in the capital employed. But no fic ous asset (such as deferred expenses) should be
included within capital employed. If informa on is available, then average capital employed shall be
taken.

(iii) Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested in the
firm. This ra o reveals how profitably owners' funds have been u lised by the firm. It also measures the
percentage return generated to equity shareholders. This ra o is computed as:

Return on equity is one of the most important indicators of a firm's profitability and poten al growth.
Companies that boast a high return on equity with li le or no debt are able to grow without large capital
expenditures, allowing the owners of the business to withdraw cash and reinvest it elsewhere. Many
investors fail to realize, however, that two companies can have the same return on equity, yet one can be
a much be er business. If return on total shareholders is calculated then Net Profit a er taxes (before
preference dividend) shall be divided by total shareholders' fund includes preference share capital.

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Return on Equit using the Du pont Model:

A finance execu ve at E.I. Du pont de Nemours and Co., of Wilmington, Delawaer, created the DupPont
system of financial analysis in 1919. That system is used around the world today and serves as the basis of
components that make up return on equity.
There are various components in the calcula on of return on equity using the tradi onal DuPont model-
the net profit margin, asset turnover, and the equity mul plier. By examining each input individually, the
sources of a company's return on equity can be discovered and compared to its compe tors.

(i) Profitability/Net Profit Margin: The net profit margin is simply the a er-tax profit a company
generates for each rupee of revenue. Net profit margin varies across industries, making it
important to compare a poten al investment against its compe tors. Although the general rule-of-
thumb is that a higher net profit margin is preferable, it is not uncommon for management to
purposely lower the net profit margin in a bid to a ract higher sales.

Net profit margin is a safety cushion; the lower the margin, the less room for error. A business with
1% margins has no room for flawed execu on. Small miscalcula ons on management's part could
lead to tremendous losses with li le or no warning.

(ii) Investment Turnover / Asset Turnover / Capital Turnover: The asset turnover ra o is a measure of
how effec vely a company converts its assets into sales. It is calculated as follows:

The asset turnover ra o tends to be inversely related to the net profit margin i.e. higher the net
profit margin, lower the asset turnover and vice versa. The result is that the investor can compare
companies using different models (low-profit, high-volume vs. high-profit, low-volume) and
determine which one is the more a rac ve business.

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(iii) Equity Mul plier: It is possible for a company with terrible sales and margins to take on excessive
debt and ar ficially increase its return on equity. The equity mul plier, a measure of financial
leverage, allows the investor to see what por on of the return on equity is the result of debt. The
equity mul plier is calculated as follows:

Calcula on of Return on Equity

To calculate the return on equity using the DuPont model, simply mul ply the three components
(net profit margin, asset turnover, and equity mul plier.)

Return on Equity = (Profitability / Net profit margin) x (Investment Turnover / Asset Turnover /
Capital Turnover) x Equity Mul plier

Example - 1: XYZ Company's details are as under:

Revenue: ₹ 29,261; Net Income: ₹ 4,212; Assets: ₹ 27,987; Shareholders' Equity: ₹ 13,572.
CALCULATE return on equity.

Solu on
Net Profit Margin = Net Income (₹ 4,212) ÷ Revenue (₹ 29,261) = 0.14439, or 14.39%
Asset Turnover = Revenue (₹ 29,261) ÷ Assets (₹ 27,987) = 1.0455
Equity Mul plier = Assets (₹ 27,987) ÷ Shareholders' Equity (₹ 13,572) = 2.0621

Finally, we mul ply the three components together to calculate the return on equity:
Return on Equity = Net Profit Margin x Asset Turnover x Equity Mul plier
= (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%

Analysis: A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity
mul plier to see how much company would earn if it were completely debt-free, you will see that
the ROE drops to 15.04%. 15.04% of the return on equity was due to profit margins and sales, while
remaining 15.98% was due to returns earned on the debt at work in the business. If you could find a
company at a comparable valua on with the same return on equity yet a higher percentage arose
from internally-generated sales, it would be more a rac ve.

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(iii) Profitability Ra os Required for Analysis from Owner's Point of View

(a) Earnings per Share (EPS): The profitability of a firm from the point of view of ordinary shareholders can
be measured in terms of earnings on per share basis. This is known as Earnings per share. It is calculated
as follows:

(b) Dividend per Share (DPS): Earnings per share as stated above reflects the profitability of a firm per share;
it does not reflect how much profit is paid as dividend and how much is retained by the business.
Dividend per share ra o indicates the amount of profit distributed to equity shareholders per share. It is
calculated as:

Total Dividend paid to equity shareholders

Dividend per Share (DPS) =
Number of equity shares outstanding

(c) Dividend Pay-out Ra o (DP): This ra o measures the dividend paid in rela on to net earnings. It is
determined to see to how much extent earnings per share have been retained by the management for
the business. It is computed as:

Dividend per equity share (DPS)

Dividend pay - out Ratio =
Earning per Shares (EPS)

(iv) Profitability Ra os related to market/ valua on/ Investors

These ra os involve measures that consider the market value of the company's shares. Frequently, share
prices data are punched with the accoun ng data to generate new set of informa on. These are (a) Price-
Earnings Ra o, (b) Dividend Yield, (c) Market Value/ Book Value per share, (d) Q Ra o.

(a) Price- Earnings Ra o (P/E Ra o): The price earnings ra o indicates the expecta on of equity investors
about the earnings of the firm. It relates earnings to market price and is generally taken as a summary
measure of growth poten al of an investment, risk characteris cs, shareholders orienta on, corporate
image and degree of liquidity. It is calculated as

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Interpreta on
It indicates the payback period to the investors or prospec ve investors. A higher P/E ra o could either
mean that a company's stock is over-valued or the investors are expec ng high growth rates in future.

(b) Dividend and Earning Yield:

Some mes, it is calculated as:

Interpreta on
This ra o indicates return on investment; this may be on average investment or closing investment.
Dividend (%) indicates return on paid up value of shares. But yield (%) is the indicator of true return in
which share capital is taken at its market value.

Earning Yield also can be calculated as

Also known as Earnings Price (EP) Ra o.

(c) Market Value /Book Value per Share (MVBV): It provides evalua on of how investors view the
company's past and future performance.

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Interpreta on
This ra o indicates market response of the shareholders' investment. Undoubtedly, higher the ra o
be er is the shareholders' posi on in terms of return and capital gains.

(d) Q Ra o: This ra o is proposed by James Tobin, a ra o is defined as

Thus, this ra o represents the rela onship between market valua on and intrinsic value. Equilibrium is
when Q Ra o = 1 because when it is less than 1, it could mean that the stock is undervalued and when it is
more than 1, it could mean that stock is overvalued.

Notes for calcula ng Ra os:

1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes),
EAT (Earnings a er taxes) = PAT (Profit a er taxes),
EBT (Earnings before taxes) = PBT (Profit before taxes)
2. In absence of preference dividend PAT can be taken as earnings available to equity shareholders.
3. If informa on is available then average capital employed shall be taken while calcula ng ROCE.
4. Ra os shall be calculated based on requirement and availability of informa on and may deviate
from original formulae. If required, assump ons should be given.
5. Numerator should be taken in correspondence with the denominator and vice-versa.

USERS AND OBJECTIVE OF FINANCIAL ANALYSIS:- A BIRDS EYE VIEW

Financial Statement analysis is useful to various shareholders to obtain the derived informa on about the firm
S. Users Objec ves Ra os used in general
No.
1. Shareholders Being owners of the organisa on w Mainly Profitability Ra os [In
they are interested to know par cular Earning per share (EPS),
about profitability and growth of Dividend per share (DPS), Price Earnings
the organiza on (P/E), Dividend Payout ra o (DP)]
2. Investors They are interested to know w Profitability Ra os
overall financial health of the w Capital structure Ra os
organisa on par cularly future w Solvency Ra os
perspec ve of the organisa ons. w Turnover Ra os

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3. Lenders They will keep an eye on the safety w Coverage Ra os

perspec ve of their money lent to the w Solvency Ra os
organisa on w Turnover Ra os
w Profitability Ra os
4. Creditors They are interested to know liability w Liquidity Ra os
posi on of the organisa on par cularly w Short term solvency Ra os/
in short term. Creditors would like to Liquidity Ra os
know whether the organisa on will be
able to pay the amount on due date.

5. Employees They will be interested to know the w Liquidity Ra os

overall financial wealth of the w Long term solvency Ra os
organisa on and compare it with w Profitability Ra os
compe tor company. w Return on investment
6. Regulator / They will analyse the financial w Profitability Ra os
Government statements to determine taxa ons and
other details payable to the government.
7. Managers:-
(a) They are interested to know about data w Input output Ra o
Produc on regarding input output, produc on w Raw material consump on ra o.
Managers quan es etc.
(b) Sales Data related to units sold for various w Turnover ra os (basically
Managers years, other associated figures and receivable turnover ra o)
predicted future sales figure will be an w Expenses Ra os
area of interest for them
(c) Financial They are interested to know various w Profitability Ra os (par cularly
Manager ra os for their future predic ons of related to Return on investment)
financial requirement. w Turnover ra os
w Capital Structure Ra os
(d) Chief They will try to assess the complete w All Ra os
Execu ve/ perspec ve of the company, star ng
General from Sales, Finance, Inventory, Human
Manager resources, Produc on etc.

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8. Different
Industry
(a) Telecom w Ra o related to 'call'
w Revenue and expenses per
customer
(b) Bank w Loan to deposit Ra os
Finance Manager /Analyst will calculate
w Opera ng expenses and income
ra os of their company and compare it
ra os
with Industry norms.
(c) Hotel w Room occupancy ra o
w Bed occupancy Ra os
w Passenger - kilometre
w Opera ng cost - per passenger
kilometre

APPLICATION OF RATIO ANALYSIS IN FINANCIAL DECISION MAKING

A popular technique of analysing the performance of a business concern is that of financial ra o analysis. As a
tool of financial management, they are of crucial significance.
The importance of ra o analysis lies in the fact that it presents facts on a compara ve basis and enables
drawing of inferences regarding the performance of a firm.
Ra o analysis is relevant in assessing the performance of a firm in respect of following aspects:
Financial Ra os for Evalua ng Performance
(a) Liquidity Posi on: With the help of ra o analysis one can draw conclusions regarding liquidity posi on of
a firm. The liquidity posi on of a firm would be sa sfactory if it is able to meet its obliga ons when they
become due. This ability is reflected in the liquidity ra os of a firm. The liquidity ra os are par cularly
useful in credit analysis by banks and other suppliers of short-term loans.
(b) Long-term Solvency: Ra o analysis is equally useful for assessing the long-term financial viability of a
firm. This aspect of the financial posi on of a borrower is of concern to the long term creditors, security
analysts and the present and poten al owners of a business.
The long term solvency is measured by the leverage/capital structure and profitability ra os which focus
on earning power and opera ng efficiency.
The leverage ra os, for instance, will indicate whether a firm has a reasonable propor on of various
sources of finance or whether it is heavily loaded with debt in which case its solvency is exposed to
serious strain.
Similarly, the various profitability ra os would reveal whether or not the firm is able to offer adequate
return to its owners consistent with the risk involved.

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(c) Opera ng Efficiency: Ra o analysis throws light on the degree of efficiency in the management and
u lisa on of its assets.
The various ac vity ra os measure this kind of opera onal efficiency. In fact, the solvency of a firm is, in
the ul mate analysis, dependent upon the sales revenues generated by the use of its assets – total as
well as its components.
(d) Overall Profitability: Unlike the outside par es which are interested in one aspect of the financial
posi on of a firm, the management is constantly concerned about the overall profitability of the
enterprise. That is, they are concerned about the ability of the firm to meet its short-term as well as long-
term obliga ons to its creditors, to ensure a reasonable return to its owners and secure op mum
u lisa on of the assets of the firm. This is possible if an integrated view is taken and all the ra os are
considered together.
(e) Inter-firm Comparison: Ra o analysis not only throws light on the financial posi on of a firm but also
serves as a stepping stone to remedial measures. This is made possible due to inter-firm
comparison/comparison with industry averages.
A single figure of par cular ra o is meaningless unless it is related to some standard or norm. One of the
popular techniques is to compare the ra os of a firm with the industry average. It should be reasonably
expected that the performance of a firm should be in broad conformity with that of the industry to which
it belongs.
An inter-firm comparison would demonstrate the rela ve posi on vis-a-vis its compe tors. If the results
are at variance either with the industry average or with those of the compe tors, the firm can seek to
iden fy the probable reasons and, in the light, take remedial measures.
Ra os not only perform post mortem of opera ons, but also serve as barometer for future. Ra os have
predictor value and they are very helpful in forecas ng and planning the business ac vi es for a future.
Conclusions are drawn on the basis of the analysis obtained by using ra o analysis. The decisions affected
may be whether to supply goods on credit to a concern, whether bank loans will be made available, etc.
(f) Financial Ra os for Budge ng: In this field ra os are able to provide a great deal of assistance. Budget is
only an es mate of future ac vity based on past experience, in the making of which the rela onship
between different spheres of ac vi es are invaluable.
It is usually possible to es mate budgeted figures using financial ra os.
Ra os also can be made use of for measuring actual performance with budgeted es mates. They
indicate direc ons in which adjustments should be made either in the budget or in performance to bring
them closer to each other.
LIMITATIONS OF FINANCIAL RATIOS
The limita ons of financial ra os are listed below:
(i) Diversified product lines: Many businesses operate a large number of divisions in quite different
industries. In such cases ra os calculated on the basis of aggregate data cannot be used for inter-firm
comparisons.

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(ii) Financial data are badly distorted by infla on: Historical cost values may be substan ally different from
true values. Such distor ons of financial data are also carried in the financial ra os.
(iii) Seasonal factors: It may also influence financial data.
Example: A company deals in co on garments. It keeps a high inventory during October - January every
year. For the rest of the year its inventory level becomes just 1/4th of the seasonal inventory level.
So, the liquidity ra os and inventory ra os will produce biased picture. Year end picture may not be the
average picture of the business. Some mes it is suggested to take monthly average inventory data
instead of year end data to eliminate seasonal factors. But for external users it is difficult to get monthly
inventory figures. (Even in some cases monthly inventory figures may not be available).
(iv) To give a good shape to the popularly used financial ra os (like current ra o, debt- equity ra os, etc.):
The business may make some year-end adjustments. Such window dressing can change the character of
financial ra os which would be different had there been no such change.
(v) Differences in accoun ng policies and accoun ng period: It can make the accoun ng data of two firms
non-comparable as also the accoun ng ra os.
(vi) No standard set of ra os against which a firm's ra os can be compared: Some mes a firm's ra os are
compared with the industry average. But if a firm desires to be above the average, then industry average
becomes a low standard. On the other hand, for a below average firm, industry averages become too
high a standard to achieve.
(vii) Difficulty to generalise whether a par cular ra o is good or bad: For example, a low current ra o may be
said 'bad' from the point of view of low liquidity, but a high current ra o may not be 'good' as this may
result from inefficient working capital management.
(viii) Financial ra os are inter-related, not independent: Viewed in isola on one ra o may highlight
efficiency. But when considered as a set of ra os they may speak differently. Such interdependence
among the ra os can be taken care of through mul variate analysis (analyzing the rela onship between
several variables simultaneously).
Financial ra os provide clues but not conclusions. These are tools only in the hands of experts because there is
no standard ready-made interpreta on of financial ra os.
FINANCIAL ANALYSIS
It may be of two types: - Horizontal and ver cal:
Horizontal Analysis: When financial statement of one year are analysed and interpreted a er comparing with
another year or years, it is known as horizontal analysis. It can be based on the ra os derived from the financial
informa on over the same me span.
Ver cal Analysis: When financial statement of single year is analyzed then it is called ver cal analysis. This
analysis is useful in inter firm comparison. Every item of Profit and loss account is expressed as a percentage of
gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm.
SUMMARY OF RATIOS
Another way of categorizing the ra os is being shown to you in a tabular form. A summary of the ra os has
been tabulated as under:

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SUMMARY OF RATIOS
Ra o Formulae Interpreta on

Liquidity Ra o

Current Current Assets A simple measure that es mates whether

Ra o Current Liabilities the business can pay short term debts.

Quick Quick Assets It measures the ability to meet current

Ra o Current Liabilities debt immediately. Ideal ra o is 1

(Cash and Bank balaces +

Cash It measures absolute liquidity of the
Marketable securities) business.
Ra o Current Liabilities

Basic æ Cash and Bank balaces + Net ö

Defense ç ÷ It measures the ability of the business to
Interval è Receivables + Marketable securities ø meet regular cash expenditures.
Ra o Operating Expenses ¸ No.of days

Net It is a measure of cash flow to determine

Working Current Assets – Current Liabili es the ability of business to survive financial
Capital crisis.
Ra o
Capital Structure Ra o

Equity Shareholder's Equity It indicates owner's fund in companies to

Ra o Net Assets total fund invested.

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Debt Total Debt

It is an indicator of use of outside funds.
Ra o Net Assets

Debt to Total Outside Liabilities It indicates the composi on of capital

equity Shareholders Equity structure in terms of debt and equity.
Ra o

Debt to
Total Total Outside Liabilities It measures how much of total assets is
Assets Total Assets financed by the debt.
Ra o
æ Preference Share Capital + Debentures ö It shows the propor on of fixed interest
Capital ç ÷ bearing capital to equity shareholders'
è + Other Borrowed funds ø
Gearing æ Equity Share Captital + ö
fund. It also signifies the advantage of
financial leverage to the equity
Ra o ç ÷
è Reseves and Surplus - Losses ø shareholder.

Proprietary Proprietary Fund It measures the propor on of total assets

Ra o Total Assets financed by shareholders.

Coverage Ra os

Debt Service It measures the ability to meet the

Earnings avaialable for debt services commitment of various debt services like
Coverage
Ra o Interest + Instalments interest, instalment etc.
(DSCR) Ideal ra o is 2.

Interest It measures the ability of the business to

EBIT
Coverage Interest
meet interest obliga ons.
Ideal ra o is > 1.
Ra o

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Preference It measures the ability to pay the

Dividend Net Profit / Earnings after taxes (EAT)
preference shareholders' dividend.
Coverage Preferences divident liability
Ideal ra o is > 1.
Ra o
Fixed This ra o shows how many mes the
Charges EBIT + Depreciation cash flow before interest and taxes covers
Coverage Interest + Repayment of loan all fixed financing charges.
Ra o Ideal ra o is > 1.

Ac vity Ra o/ Efficiency Ra o/ Performance Ra o/ Turnover Ra o

Total A measure of total asset u lisa on. It

Asset Sales / Cost of Goods Sold helps to answer the ques on - What sales
Turnover Average Total Assets are being generated by each rupee's
Ra o worth of assets invested in the business?

Fixed This ra o is about fixed asset capacity. A

reducing sales or profit being generated
Assets Sales / Cost of Goods Sold
from each rupee invested in fixed assets
Turnover Fixed Assets may indicate overcapacity or poorer
Ra o performing equipment.

Capital This indicates the firm's ability to

Turnover Sales / Cost of Goods Sold
generate sales per rupee of long term
Ra o Net Assets investment.

Working
Capital Sales / COGS It measures the efficiency of the firm to
Turnover Working Capital use working capital.
Ra o

Inventory COGS / Sales It measures the efficiency of the firm to

Turnover Average Inventory manage its inventory.
Ra o

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Debtors
Credit Sales It measures the efficiency at which firm is
Turnover Average Accounts Receivables managing its receivables
Ra o

Receivables Average Accounts Receivables It measures the velocity of collec on of

(Debtors') Average Daily Credit Sales receivables
Velocity

Payables Annual Net Credit Purchases It measures the velocity of payables

Turnover Average Accounts Payables payment.
Ra o
Profitability Ra os based on Sales

This ra o tells us something about the

Gross Gross Profit business's ability consistently to control
Profit Sales
x 100 its produc on costs or to manage the
Ra o margins it makes on products it buys and
sells.

Net
Net Profit It measures the rela onship between net
Profit x 100
profit and sales of the business.
Sales
Ra o

Opera ng Operating Profit It measures opera ng performance of

Profit Sales
x 100 business.
Ra o

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Expenses Ra o

Cost of
Goods Sold COGS
x 100
(COGS) Sales
Ra o
æ Administrative exp. + ö
Opera ng ç ÷
Expenses ç Selling and Distribution Overhead ÷ x 100
ç Sales ÷
Ra o ç ÷
è ø It measures por on of a par cular
expenses in comparison to sales.
Opera ng COGS + Operating expenses
x 100
Ra o Sales

Financial Financial expenses

Expenses Sales
x 100
Ra o
Profitability Ra os related to Overall Return on Assets/ Investments

Return on Re turn / Profit / Earnings

It measures overall return of the business
Investment x 100 on investment/ equity funds/capital
Investments employed/ assets.
(ROI)

Return on Net Profit after taxes It measures net profit per rupee of
Assets Average total assets
average total assets/ average tangible
(ROA) assets/ average fixed assets.

Return on
Capital EBIT
Employed x 100
ROCE Capital Employed
(Pre-tax) It measures overall earnings (either pre-
Return on tax or post tax) on total capital employed.
Capital EBIT (1 - t)
Employed x 100
ROCE Capital Employed
(Post-tax)

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Net Profit after taxes

Return on Preferences dividend (if any)
It indicates earnings available to equity
Equity x 100 shareholders in comparison to equity
Networth / Equity
(ROE) shareholders' net worth.
shareholders' fund
Profitability Ra os Required for Analysis from Owner's Point of View

Earnings Net profit available to equity

per EPS measures the overall profit generated
shareholders for each share in existence over a
Share par cular period.
Number of equity shares outstanding
(EPS)
Dividend
per Dividend paid to equity shareholders Propor on of profit distributed per equity
Share Number of equity shares outstanding share.
(DPS)

Dividend Dividend per equity share It shows % of EPS paid as dividend and
payout retained earnings.
Ra o (DP) Earning per share (EPS)

Profitability Ra os related to market/ valua on/ Investors

At any me, the P/E ra o is an indica on

Price- of how highly the market "rates" or
Earnings Market Price per Share (MPS) "values" a business. A P/E ra o is best
per Share Earning per share (EPS) viewed in the context of a sector or
(P/E Ra o) market average to get a feel for rela ve
value and stock market pricing.
Dividend ± Change in share price
x 100
Initial share price
Dividend OR It measures dividend paid based on
Yield Dividend per Share (DPS)
market price of shares.
x 100
Market Price per Share (MPS)

Earnings Earnings per Share (DPS)

x 100
It is the rela onship of earning per share
Yield Market Price per Share (MPS) and market value of shares

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Market
Value / Market value per share It indicates market response of the
Book Value Book value per share shareholders' investment.
per Share

It measures market value of equity as

Market Value of equity and liabilities
Q Ra o Estimated replacement cost of assets
well as debt in comparison to all assets at
their replacement cost.

CALCUATION OF RATIOS

A Ques on 1 [Study Material, (5 Marks) CA Inter N20, (4 Marks) CA IPCC N10(Similar), CA Final J96(Similar)]

L X Co. has made plans for the next year. It is es mated that the company will employ total assets of ₹
P 8,00,000; 50% of the assets being financed by borrowed capital at an interest cost of 8% per year. The
H direct costs for the year are es mated at ₹ 4,80,000 and all other opera ng expenses are es mated at ₹
80,000. The goods will be sold to customers at 150% of the direct costs. Income-tax rate is assumed to be
A
50%.

You are required to CALCULATE:

(a) Net Profit margin;
(b) Return on assets;
(c) Assets turnover, and
(d) Return on owner's equity

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