STUDY. LEARN. SHARE.

FINANCIAL RATIOS
GLOSSARY

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 Important types of ratios and their significance:

♦ Liquidity ratios
♦ Turnover ratios
♦ Profitability ratios
♦ Investment on capital/return ratios
♦ Leverage ratios
♦ Coverage ratios

Liquidity ratios:

o Current ratio: Formula = Current assets/Current liabilities.

Min. Expected even for a new unit in India = 1.33:1.

Significance = Net working capital should always be positive. In short, the higher the net
working capital, the greater is the degree of overall short-term liquidity. Means current
ratio does indicate liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding such
liquidity. This means that we are carrying either cash in large quantities or inventory in
large quantities or receivables are getting delayed. All these indicate higher costs. Hence,
if you are too liquid, you compromise with profits and if your liquidity is very thin, you run
the risk of inadequacy of working capital.

Range – No fixed range is possible. Unless the activity is very profitable and there are no
immediate means of reinvesting the excess profits in fixed assets, any current ratio above
2.5:1 calls for an examination of the profitability of the operations and the need for high
level of current assets. Reason = net working capital could mean that external borrowing is
involved in this and hence cost goes up in maintaining the net working capital. It is only a
broad indication of the liquidity of the company, as all assets cannot be exchanged for
cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio”
or “acid test ratio”.

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 o Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted into cash.
This assumes that all other current assets like receivables can be converted into cash easily.
This ratio examines whether the quick assets are sufficient to cover all the current
liabilities. Some of the authors indicate that the entire current liabilities should not be
considered for this purpose and only quick liabilities should be considered by deducting
from the current liabilities the short-term bank borrowing, as usually for an on going
company, there is no need to pay back this amount, unlike the other current liabilities.

Significance = coverage of current liabilities by quick assets. As quick assets are a part of
current assets, this ratio would obviously be less than current ratio. This directly indicates
the degree of excess liquidity or absence of liquidity in the system and hence for proper
measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not
be too high as the opportunity cost associated with high level of liquidity could also be high.

What is working capital gap? The difference between all the current assets known as
“Gross working capital” and all the current liabilities other than “bank borrowing”. This gap
is met from one of the two sources, namely, net working capital and bank borrowing. Net
working capital is hence defined as medium and long-term funds invested in current assets.

Turn over ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the
higher the degree of efficiency and hence these assume significance. Further, depending
upon the type of turn over ratio, indication would either be about liquidity or profitability
also. For example, inventory or stocks turn over would give us a measure of the
profitability of the operations, while receivables turn over ratio would indicate the liquidity
in the system.

o Debtors turn over ratio – this indicates the efficiency of collection of receivables and
contributes to the liquidity of the system. Formula = Total credit sales/Average debtors

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 outstanding during the year. Hence the minimum would be 3 to 4 times, but this
depends upon so many factors such as, type of industry like capital goods, consumer
goods – capital goods, this would be less and consumer goods, this would be
significantly higher;
Conditions of the market – monopolistic or competitive – monopolistic, this would be
higher and competitive it would be less as you are forced to give credit;

Whether new enterprise or established – new enterprise would be required to give higher
credit in the initial stages while an existing business would have a more fixed credit policy
evolved over the years of business;
Hence any deterioration over a period of time assumes significance for an existing business
– this indicates change in the market conditions to the business and this could happen due
to general recession in the economy or the industry specifically due to very high capacity or
could be this unit employs outmoded technology, which is forcing them to dump stocks on
its distributors and hence realisation is coming in late etc.

o Average collection period = inversely related to debtors turn over ratio. For example
debtors turn over ratio is 4. Then considering 360 days in a year, the average collection
period would be 90 days. In case the debtors turn over ratio increases, the average
collection period would reduce, indicating improvement in liquidity. Formula for
average collection period = 360/receivables turn over ratio. The above points for
debtors turn over ratio hold good for this also. Any significant deviation from the past
trend is of greater significance here than the absolute numbers. No minimum and no
maximum.

o Inventory turn over ratio – as said earlier, this directly contributes to the profitability of
the organisation. Formula = Cost of goods sold/Average inventory held during the year.
The inventory should turn over at least 4 times in a year, even for a capital goods
industry. But there are capital goods industries with a very long production cycle and in
such cases, the ratio would be low. While receivables turn over contributes to liquidity,
this contributes to profitability due to higher turn over. The production cycle and the
corporate policy of keeping high stocks affect this ratio. The less the production cycle,

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 the better the ratio and vice-versa. The higher the level of stocks, the lower would be
the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges.

o Current assets turn over ratio – not much of significance as the entire current assets
are involved. However, this could indicate deterioration or improvement over a period
of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current
assets held in business during the year. There is no min. Or maximum. Again this
depends upon the type of industry, market conditions, management’s policy towards
working capital etc.

o Fixed assets turn over ratio

Not much of significance as fixed assets cannot contribute directly either to liquidity or
profitability. This is used as a very broad parameter to compare two units in the same
industry and especially when the scales of operations are quite significant. Formula =
Cost of goods sold/Average value of fixed assets in the period (book value).

Profitability ratios -Profit in relation to sales and profit in relation to assets:

o Profit in relation to sales – this indicates the margin available on sales;

o Profit in relation to assets – this indicates the degree of return on the capital employed
in business that means the earning efficiency. Please appreciate that these two are
totally different.

For example, we will study the following;

Units A and B are in the same type of business and operate at the same levels of capacities.
Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and
profits are as under:

Parameter Unit A Unit B

Sales 1000lacs 1000lacs

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Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed.

o Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –

Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of
production before selling, general, administrative expenses and interest charges. Net sales
= Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to
compare with another unit in the same industry or in the same unit for comparing it with
past trend. For example in Unit A and Unit B let us assume that the sales are same at
Rs.100lacs.

Parameter Unit A Unit B

Sales 100lacs 100lacs

Cost of production 60lacs 65lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs
Net profit 5lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in
the fact that while Unit A has less cost of production and more office and selling expenses,
Unit B has more cost of production and less of office and selling expenses. This ratio helps
in controlling either production costs if cost of production is high or selling and
administration costs, in case these are high.

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 Net profit/sales ratio – net profit means profit after tax but before distribution in any form
= Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating
efficiency directly in the sense that a unit having higher net profitability percentage means
that it has a higher operating efficiency. In case there are tax concessions due to location in
a backward area, export activity etc. available to one unit and not available to another unit,
then this comparison would not hold well.

Investment on capital ratios/Earnings ratios:

o Return on net worth

Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds
including Preference Share capital. Hence Preference Share capital is not deducted.
There is no standard range for this ratio. If it reduces it indicates less return on the net
worth.

o Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference
share capital. Although reference is equity here, all equity shareholders’ funds are taken
in the denominator. Hence Preference dividend and Preference share capital are
excluded. There is no standard range for this ratio. If it comes down over a period it
means that the profitability of the organisation is suffering a setback.

o Return on capital employed (pre-tax)

Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities.
This gives return on long-term funds employed in business in pre-tax terms. Again there
is no standard range for this ratio. If it reduces, it is a cause for concern.

o Earning per share (EPS)

Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to
equity share and not preference share. The formula is = Profit after tax (-) Preference
dividend (-) Dividend tax both on preference and equity dividend / number of equity
shares. This is an important indicator about the return to equity shareholder. In fact P/E

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 ratio is related to this, as P/E ratio is the relationship between “Market value” of the
share and the EPS. The higher the PE the stronger is the recommendation to sell the
share and the lower the PE, the stronger is the recommendation to buy the share.

This is only indicative and by and large followed. There is something known as industry
average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is
less than industry average and growth prospects are quite good, it is the time for buying
the shares, unless we know for certain that the price is going to come down further. If
on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time
for us to sell unless we expect further increase in the near future.

Leverage ratios

Leverages are of two kinds, operating leverage and financial leverage. However, we are
concerned more with financial leverage. Financial leverage is the advantage of debt
over equity in a capital structure. Capital structure indicates the relationship between
medium and long-term debt on the one hand and equity on the other hand. Equity in
the beginning is the equity share capital. Over a period of time it is net worth (-)
redeemable preference share capital.

It is well known that EPS increases with increased dose of debt capital within the same
capital structure. Given the advantage of debt also, as even risk of default, i.e., non-
payment of interest and non-repayment of principal amount increases with increase in
debt capital component, the market accepts a maximum of 2:1 at present. It can be
less. Formula for debt/equity ratio = Medium and long-term loans + redeemable
preference share capital / Net worth (-) Redeemable preference share capital.

From the working capital lending banks’ point of view, all liabilities are to be included in
debt. Hence all external liabilities including current liabilities are taken into account for
this ratio. We have to add redeemable preference share capital and reduce from the
net worth the same as in the previous formula.

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Coverage ratios

o Interest coverage ratio

This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest
payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1.
Less than that is not desirable, as after paying interest, tax has to be paid and
afterwards dividend and dividend tax.

o Asset coverage ratio

This indicates the number of times the medium and long-term liabilities are covered by
the book value of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities.
Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the
liabilities.

o Debt Service coverage ratio

This indicates the ability of the business enterprise to service its borrowing, especially
medium and long-term. Servicing consists of two aspects namely, payment of interest
and repayment of principal amount. As interest is paid out of income and booked as an
expense, in the formula it gets added back to profit after tax. The assumption here is
that dividend is ignored. In case dividend is paid out, the formula gets amended to
deduct from PAT dividend paid and dividend tax.

Formula is:
(Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written
off (+) Interest on medium and long-term borrowing
(Denominator) Interest on medium and long-term borrowing (+) Installment on medium
and long-term borrowing.

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 This is assuming that dividend is not paid. In the case of an existing company dividend
will have to be paid and hence in the numerator, instead of PAT, retained earnings
would appear. The above ratio is calculated for the entire period of the loan with the
bank/financial institution. The minimum acceptable average for the entire period is
1.75:1. This means that in one year this could be less but it has to be made up in the
other years to get an average of 1.75:1.

What is the objective behind analysis of financial statements?

Objective (To know about) Relevant indicator/Remarks

1. Financial position of the company
Net worth, i.e., share capital, reserves and
unallocated surplus in balance sheet carried
down from profit and loss appropriation
account. For a healthy company, it is
necessary that there is a balance struck
between dividend paid and profit retained in
business so much the net worth keeps on
increasing.

2. Liquidity of the company, i.e., whether Current ratio and quick ratio or acid test
the company is in a position to meet all ratio. Current ratio = Current assets/current
its short-term liabilities (also called liabilities. Quick ratio = Current assets (-)
“current liabilities”) with the help of its inventory/ current liabilities. Current ratio
current assets should not be too high like 4:1 or 5:1 or too
low like less than 1.5:1. This means that the
company is either too liquid thereby
increasing its opportunity cost or not liquid
at all, both of which are not desirable. Quick
ratio could be at least 1:1. Quick ratio is a

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 better indicator of liquidity position.

3. Whether the company has acquired new Examination of increase in secured or

fixed assets during the year and if so, unsecured loans for this purpose. Without
what are the sources, besides internal adequate financial planning, there is always
accruals to finance the same? the risk of diverting working capital funds for
fixed assets. This is best assessed through a
funds flow statement for the period as even
net cash accruals (Retained earnings +
depreciation + amortisation) would be
available for fixed assets.

4. Profitability of the company in general Percentage of profit before tax to total

and operating profits in particular, i.e., income including other income, like dividend
whether the main operations of the or interest income. Operating profit, i.e.,
company like manufacturing have been profit before tax (-) other income as above
in profit or the profit of the company is as a percentage of income from the main
derived from other income, i.e., income operations of the company, be it
from investment in shares/debentures manufacturing, trading or services.
etc.

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5. Relationship between the net worth of Debt/Equity ratio, which establishes this
the company and its external liabilities relationship. Formula = External liabilities +
(both short-term and long-term). What preference share capital /net worth of the
about only medium and long-term company (-) preference share capital
debts? (redeemable kind). From the lender’s point
of view, this should not exceed 3:1. Is there
any sharp deterioration in this ratio? Is so,
please be on guard, as the financial risk for
the company increases to that extent.
For only medium and long-term debts, it
cannot exceed 2:1.

6. Has the company’s investments in Difference between the market value of the
shares/debentures of other companies investments and the purchase price, which is
reduced in value in comparison with last theoretically a loss in value of the
year? investment. Actual loss is booked upon only
selling. The periodic reduction every year
should warn us that at the time of actual
sales, there would be substantial loss, which
immediately would reduce the net worth of
the company. Banks, Financial Institutions,
Investment companies or NBFCs would be
required to declare their investment every
year in the balance sheet at cost price or
market price whichever is less.

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7. Relationship between average debtors Average
(bills receivable) and average creditors creditors in the year. This should be greater
(bills payable) during the year.
debtors in the year/average
than 1:1, as bills receivable are at gross value
{cost of development (+) profit margin},
whereas; creditors are at purchase price for
software or components, which would be
much less than the final sales value. If it is
less than 1:1, it shows that while receivable
management is quite good, the company is
not paying its creditors, which could cause
problems in future. Too high a ratio would
indicate that receivable management is very
poor.

8. Future plans of the company, like Directors’ report. This would reveal the
acquisition of new technology, entering financial plans for the company, like whether
into new collaboration agreement, they are coming out with a public
diversification programme, expansion issue/Rights issue etc.
programme etc.

9. Has the company revalued its fixed Auditors’ comments in the “Notes to
assets during the year, thereby creating Accounts” relevant for this. Frequent
revaluation reserves, without any inflow revaluation is not desirable and healthy.
of capital into the company, as this is just
an entry passed in the books?

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10. Whether the company has increased its Increase in amount of investment in
investment and if so, what is the source shares/debentures/Govt. securities etc. in
for it? What is the nature of investment? comparison with last year and any
Is it in tradable securities or long-term investment within group companies? Any
Securities, which can have a lock-in- undue increase in investment should put us
period and cannot be liquidated in the on guard, as working capital funds could
near future? have been diverted for it.

11. Has the company during the year given Any increase in unsecured loans. If the loans
any unsecured loans substantially other are to group companies, then all the more
than to employees of the company? reason to be cautious. Hence, where the
figures have increased, further probing is
called for.

12. Are the company’s unsecured loans Any comments to this effect in the notes to
(given) not recoverable and very old? accounts should put us on caution. This
examination would indicate about likely
impact on the future profits of the company.

13. Has the company been regular in Any comments about over dues as in the
payment of its dues on account of loans “Notes to Accounts” should be looked into.
or periodic interest on its liabilities? Any serious default is likely to affect the
“credit rating” of the company with its
lenders, thereby increasing its cost of
borrowing in future.

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14. Has the company defaulted in providing Any comments about this in the “Notes to
for bonus liability, P.F. liability, E.S.I. Accounts” should be looked into.
liability, gratuity
liability etc?

15. Whether the company is holding very Cash balance together with bank balance in
huge cash, as it is not desirable and current account, if any, is very high in the
increases the opportunity cost? current assets.

16. How many times the average inventory Relationship between cost of goods sold and
has turned over during the year?
average inventory during the year (only
where cost of goods sold cannot be
determined, net sales can be taken as the
numerator). In a manufacturing company,
which is not in capital goods sector, this
should not be less than 4:1 and for a
consumer goods industry, this should be
higher even. For a capital goods industry,
this would be less.

17. Has the company issued fresh share Increase in paid-up capital in the balance
capital during the period and what is the sheet and share premium reserves in case
purpose for which it has raised equity the issue has been at a premium.
capital? If it was a public issue, how did
it fare in the market?

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18. Has the company issued any bonus Increase in paid-up capital and simultaneous
shares during the year? reduction in general reserves. Enquiry into
the company’s ability to keep up the
dividend rate of the immediate past.

19. Has the company made any rights issue Increase in paid-up capital and share
in the period and what is the purpose of premium reserves, in case the issue has been
the issue? If it was a public issue, how at a premium.
did it fare in the market?

20. What is the proportion of marketable Percentage of marketable investment to

investment to total investment and total investment and comparison with
whether this has decreased in previous year. Any decrease should put us
comparison with the previous year? on guard, as it reduces liquidity on one hand
and increases the risk of non-payment on
due date, especially if the investment is in its
own subsidiary or group companies, thereby
forcing the company to provide for the loss.

21. What is the increase in sales income over Comparison with previous year’s sales
last year in % terms? Is it due to increase income and whether the growth has been
in numbers or change in product mix or more or less than the estimate.
increase in prices of finished products
only?

22. What is the amount of provision for bad In percentage terms, how much is it of total
and doubtful debts or advances debts outstanding and what are the reasons

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 outstanding? for such provision in the notes to accounts
by the auditors?

23. What is the amount of work in progress Is there any comment about valuation of
as shown in the Profit and Loss Account? work in progress by the auditors? It can be
seen that profit from operations can be
manipulated by increase/decrease in closing
stocks of both finished goods and work in
progress.

24. Whether the company is paying any Examination of expenses schedule would
lease rentals and if so what is the show this. What is the comment in notes to
amount of lease liability outstanding? accounts about this? Lease liability is an off-
balance sheet item and hence this
examination, to ascertain the correct
external liability and to include the lease
rentals in future also in projected income
statements; otherwise, the company may be
having much less disclosed liability and much
more lease liability which is not disclosed.
This has to be taken into consideration by an
analyst while estimating future expenses for
the purpose of estimating future profits.

25. Has the company changed its method of Auditors’ comments on “Accounting”
depreciation on fixed assets, due to policies. Change over from straight-line
which, there is an impact on the profits method to written down value method or
of the company? vice-versa does affect the deprecation
charge for the year thereby affecting the

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 profits during the year of change.

26. If it is a manufacturing company, Relationship between materials consumed

whether the % of materials consumed is during the year and the sales.
increasing in relation to sales?

27. Has the company changed its method of Auditors’ comments on “Accounting”
valuation of inventory, due to which policies.
there is an impact of the profits of the
company?

28. Whether the % of administration and Relationship between general and

general expenses has increased during administrative expenses during the year and
the year under review? the sales. In case there is any extraordinary
increase, what are the reasons therefore?

29. Whether the company had sufficient Interest coverage ratio = earnings before
income to pay the interest charges? interest and tax/total interest on all short-
term and long-term liabilities. Minimum
should be 3:1 and anything less than this is
not satisfactory.

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30. Whether the finance charges have gone Relationship between interest charges and
up disproportionately as compared with sales income – whether it is consistent with
the increase in sales income during the the previous year or is there any spurt?
same period? Is there any explanation for this, like
substantial expansion or new project or
diversification for which the company has
taken financial assistance? While a
benchmark % is not available, any level in
excess of 6% calls for examination.

31. Whether the % of employee costs to Relationship between “payment to and

sales has increased? provision for employees” and the sales. In
case any undue increase is seen, it could be
due to expansion of activity etc. that would
be included in the Directors’ Report.

32. Whether the % of selling expenses in Relationship between “selling and

relation to sales has gone up? marketing” expenses and the sales. Any
undue increase could either mean that the
company is in a very competitive industry or
it is aggressive to increase its market share
by adopting a marketing strategy that would
increase the marketing expenses including
offer of higher commission to the
intermediaries like agents etc.

33. Whether the company had sufficient Debt service coverage ratio = Internal
internal accruals {Profit after tax (-) accruals (+) interest on medium and long-

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 dividend (+) any non-cash expenditure term external liabilities/interest on medium
like depreciation, preliminary expenses and long-term liabilities (+) repayment of
write-off etc.} to meet repayment medium and long-term external liabilities.
obligation of principal amount of loans, The term-lending institution or bank looks
debentures etc.? for 1.75:1 on an average for the loan period.
This is a very critical ratio to indicate the
ability of the company to take care of its
obligation towards the loans it has taken
both by way of interest as well as repayment
of the principal.

34. Return on investment in business to Earnings before interest and tax/average

compare it with return on similar total invested capital, i.e., net worth (+) debt
investment elsewhere. capital. This should be higher than the
average cost of funds in the form of loans,
i.e., interest cost on loans/debentures etc.

35. Return on equity (includes reserves and Profit after tax (-) dividend on preference
surplus) share capital/net worth (-) preference share
capital (return in percentage). Anything less
than 15% means that our investment in this
company is earning less than the average
return in the market.

36. How much earning has our share made? Profit after tax (-) dividend on preference
(EPS) share capital/number of equity shares. In
terms of percentage anything less than 40%
to 50% of the face value of the shares would
not go well with the market sentiments.

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37. Whether the company has reduced its Relationship between amount of dividend
dividend payout in comparison with last payout and profit after tax last year and this
year? year. Is there any reason for this like
liquidity crunch that the company is
experiencing or the need for conserving cash
for business activity, like purchase of fixed
assets in the immediate future?

38. Is there any significant increase in the “Notes on Accounts” as given at the end of
contingent liabilities due to any of the the accounts.
following? Any substantial increase especially in
Disputed central excise duty, customs disputed amount of duties should put us on
duty, income tax, octroi, sales tax, guard.
contracts remaining unexecuted,
guarantees given by the banks on behalf
of the company as well as the guarantees
given by the company on behalf of its
subsidiary or associate company, letter
of credit outstanding for which goods not
yet received etc.

39. Has the company changed its policy of Substantial change in vendor charges, or
outsourcing its work from vendors and if subcontracting charges.
so, what are the reasons?

40. Is there any substantial increase in Increase in consultancy charges.

charges paid to consultants?

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41. Has the company opened any branch Directors’ Report or sudden spurt in general
office in the last year? and administration expenses.

The principal tools of analysis are:

♦ Ratio analysis – i.e. to determine the relationship between any set of two parameters and
compare it with the past trend. In the statements of accounts, there are several such pairs
of parameters and hence ratio analysis assumes great significance. The most important
thing to remember in the case of ratio analysis is that you can compare two units in the
same industry only and other factors like the relative ages of the units, the scales of
operation etc. come into play.

♦ Comparison with past trend within the same company is one type of analysis and
comparison with the industrial average is another analysis

Some of the limitations of the financial statements are given below :

 Analysis and understanding of financial statements is only one of the tools in understanding
of the company

 The annual statements do have great limitations in their value, as they do not speak about
the following-

 Management, its strength, inadequacy etc.

 Key personnel behind the activity and human resources in the organisation.

 Average key ratios in the industry in the country, of which the company is an integral part.
This information has to be obtained separately.

 Balance sheet is as on a particular date and hence it does not indicate about the average
for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it with
fundamental analysis.)

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 The auditors’ report is based more on information given by the management, company
personnel etc.

 To an extent at least, there can be manipulation in the level of expenditure, level of closing
stocks and sales income to manipulate profits of the organisation, depending upon the
requirement of the management during a particular year.

 One cannot come to know from study of financial statements about the tax planning of the
company or the basis on which the company pays tax, as it is not mandatory under the
provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual
statement of accounts.

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