Financial Ratios are the perfect tool for financial analysis and it aids decision making

1. FINANCIAL RATIOS
MANAGEMENT
1

2. Financial Ratio
Analysis
2

3. RATIO
3
A ratio is a statistical yardstick that
provides a measure of the relationship
between two variables or figures.

4. 31MAR
ASSETS
31MAR
170 SHARE CAPITAL 170 213 FIXED ASSETS 229
EQUITY 120 NET 594
PREFERENCE 50 GROSS STOCK
LESS
365
180 RESERVES AND
SURPLUSES
215 11
DEPRECIATION
INTANGIBLE
ASSETS
15
150 SECURED LOANS 151 5 INVESTMENTS 5
DEBENTURES 50
LOANS /ADVANCES 101
20 UNSECURED
LOANS
30 670 CURRENT ASSETS 681
409 CURRENT
LIABILITIES
SUNDRY CREDITORS
PROVISIONS
330
69
399
30
CASH IN BANK
RECEIVABLES
INVENTORIES
PRE-PAID
EXPENSES
MISC
73
189
355
64
35
BALANCE SHEET ABC COMPANY AS AT 31st MARCH
LIABILITIES

5. MAR
847 NET SALES 904
657 COST OF GOODS SOLD 714
STOCKS 366
WAGES AND SALARIES 188
OTHER MANUFACTURING EXPENSES 160
190 GROSS PROFIT 190
103 OPERATING EXPENSES:
SELLING/ADM
DEPRECIATION
71
25
96
87 OPERATING PROFIT 94
11 NON-OPERATING PROFIT/DEFICIT 49
98 PROFIT BEFORE INTEREST&TAX 143
(EBIT)
26 INTEREST(ON BANK 29 33
BORROWINGS/LOANS)
DEBENTURES
4
72 PROFIT BEFORE TAX 110
36 TAX 58
36 PROFIT AFTER TAX 52
12 DIVIDENDS:EQUITY/ PREFERENCE 14 / 3 17

6. ■
6
A comparison is more useful than mere Nos
Analysis of financial ratios involves two types of
comparisons:
■
■ Present ratio with the past ratios & expected future
ratios
Ratios of one firm with those of similar firms or with
industry averages at same point of time
■
■ Essential to consider nature of business
(apples cannot be compared with oranges)
WHY BOTHER WITH
RATIOS?

7. CLASSIFICATION OF RATIOS
7
■ Liquidity ratios
■ Leverage / Solvency ratios
■ Turnover / Activity ratios
■ Profitability ratios
■ Valuation ratios

8. 03/24/14 9
LIQUIDITY RATIOS
■ Current ratio
■ Quick / Acid test ratio
■ Shows ability of company to pay its current financial
obligations
■ Company should not be selling its assets at a loss to meet
its financial obligations; worst scenario be forced into
liquidation

9. 12
CURRENT RATIO (CR)
■ Measure of company’s ability to meet short term
requirements
Indicates whether current liabilities are adequately
covered by current assets
Measures safety margin available for short term creditors
CR = Current assets/Current liabilities
If Net Working Capital is to be positive, CR >1
■
■
■
■

10. 13
CURRENT RATIO (CR) -
IMPORTANCE
■ Higher ratio ensures firm does not face problems in
meeting increased working capital requirements
Low ratio implies repeated withdrawls from bank to
meet liquidity requirements
High CR as compared to other firms implies advantage
of lower int rates from banks
■
■

11. 14
ACID TEST RATIO/QUICK
RATIO(QR)
■ Used to examine whether firm has adequate cash or cash
equivalents to meet current obligations without resorting to
liquidating non cash assets such as inventories
Measures position of liquidity at a point of time
QR = Quick Assets / Current Liabilities
As a thumb rule ideal QR = 1; should not be
less than 1
■
■
▪

12. 15
CLASSIFICATION OF RATIOS
■ Liquidity ratios
➔ Leverage / Solvency ratios
■ Turnover / Activity ratios
■ Profitability ratios
■ Valuation ratios

13. vis funds supplied by owners; Use of debt finance
■Companies whose EBIT <= Interest payments are risky
03/24/14 16
LEVERAGE RATIOS
■ Shows dependence of firm on outside long term finance
■Shows long term financial solvency & measures firm’s ability
to pay interest & principle regularly when due
■To assess extent to which the firm borrowed money vis-à-
■
■
■
■
■ Debt - Equity ratio
Debt - Total fund ratio
Debt - Assets ratio
Interest coverage ratio
Liability coverage ratio

14. ■
17
Measures relative proportion of debt & equity in financing assets
of a firm
Company can have good current ratio and liquidity position,
however liquidity may have come from long term borrowed
funds, the repayment of which along with interest will put
liquidity under pressure
DER = Long term debt / Share holders funds
Creditors would like this to be low; Lower ratio implies larger
credit cushion (margin of protection to creditors)
IDB expects DER of 2:1 in respect of SMEs
■
■
■
■
DEBT EQUITY RATIO

15. ■
18
Debt (loans) = Secure loans + Unsecure loans
= 151+30=181
■ Share holders funds =
res
(equity+ preference capital +
& surplus – fictitious assets &
accumulated losses not written off )
= 120+50+215 = 385
DER = 181/385 = 0.47 = (0.47:1)
Creditors are providing Rs 0.47 financing for each rupee
provided by shareholders
■
■
DEBT EQUITY RATIO

16. Financialrisk 19
DEBT – TOTAL FUND
RATIO
■ DTF ratio= Long term debt / Total fund
Debt (long term) = 181
Total funds (debt + sh holders’ funds)
= 181+( 170+215- 35) = 531
DTF ratio = 181/ 531 = 0.34
34% of the firms funds are debt (of various types)
remaining 66% is financed by owners/ share holders
Higher the debt - total funds ratio, greater the
■
■
■
■
■

17. DEBT – ASSETS RATIO
20
■ Debt - Assets ratio = Debt / Net assets
Debt = 181
Net assets (less fictitious assets & losses) =
930
Ratio = 181/930 = 0.19
19% of the firms assets are financed with debt (of
various types).
Shows coverage provided by the assets to total debt
■
■
■
■
■

18. INTEREST COVERAGE RATIO
03/24/14 21
■ Gives ability of company to pay back long term loans
along with interest or other charges from generation
of profit from its operations
Interest coverage ratio = EBIT / Debt interest
EBIT = 143
Interest = 29+4 = 33
Ratio = 143/33=4.33
EBIT should be 6 – 7 times of debt interest
Shows margin of cover to lenders; of prime imp
■
■
■
■
■
■

19. LIABILITY COVERAGE
22
RATIO
■ Calculated to determine time a company would take
to pay off all its liabilities from internally generated
funds
Assumes that liabilities will not be liquidated from
additional borrowings or from sale of assets
LCR = Internally generated funds / Total liabilities
Internally gen funds = Equity + Pref + R&S = 385
Total liabilities = 965
LCR = 385/965 = 0.399
■
■
■
■
■

20. CLASSIFICATION OF RATIOS
03/24/14 23
■ Liquidity ratios
■ Leverage / Solvency ratios
➔ Turnover / Activity ratios
■ Profitability ratios
■ Valuation ratios

21. RATIOS
■ Activity turn over ratios used to assess efficiency with
which company utilizing its assets
■Relates to level of activity represented by sales or cost of
good03/s 24/so14ld 24
■ Allows to examine whether total amount of each type of
asset a company owns is reasonable, too high or too low in
light of current and forecast operating needs
■ In order to purchase / acquire assets, companies need to
borrow or obtain Capital from elsewhere :-
■ More assets acquired implies high int and low profits
■ Lesser assets implies operations not as efficient as
possible
• Inventory turnover ratio
• Average collection period

22. ■ Measures No of times inventory turned over in a
year
OR
No of days of inventory held by company to sp
sales
■ Times Inventory turned over =
Net sales OR
Avg inventory
COGS
Avg stocks
■ Inventory measured in days of sale =
365 x Avg inventory
Net Sales
INVENTORY TURN OVER RATIO
25

23. ■
03/24/14 26
A ratio of 6 times indicates inventory turned over
six times in a year
OR
Ratio of 60 days indicates enough inventory to
support sales for 60 days held by company
Excessive inventories unproductive; represent
investment with zero rate of return
Conversely less inventory results in loss of
customers
ABC’s ratio = 904/355 = 2.54
ABC’s Days of Inv = (355 x 365)/904 = 143.33 days
■
■
■
■
INVENTORY TURN OVER RATIO

24. ■ Enables mgmt to take timely measures to effectively
manage credit
■ Too high value - firm facing difficulties in collecting debts
■ Too low value - restrictive credit policy
03/24/14 27
AVERAGE COLLECTION PERIOD
■ Represents duration a company must wait after making
sales, before it actually receives cash from its customers
■ ACP = Avg receivables
Average sales per day
Avg receivables x 365
Sales
OR
=
■ Imp
■ For assessing effectiveness of credit policy of firm
Receivables
Sales
ACP
= 189
= 904
= (189 x 365)/ 904 = 76.2 days
say 76 days

25. FIXED ASSETS TURNOVER RATIO
■ Measures effectiveness of utilization of fixed assets by
company
Used to compare fixed assets utilization of two firms
Not truly reflective of performance / efficiency
■
■
■ High ratio (depreciation) if old assets
Low ratio if capital assets procured recently
■
■ FATR = Net sales (or COGS)/ Fixed assets
■ Higher ratio indicates better utilisation of assets (with a
caution on age of assets)
03/24/14 28
= 229
Fixed Assets
Net Sales
FATR
= 904
= 904 / 229 = 3.95

26. 29
CLASSIFICATION OF RATIOS
■ Liquidity ratios
■ Leverage / Solvency ratios
■ Turnover / Activity ratios
➔ Profitability ratios
■ Valuation ratios

27. 30
PROFITABILITY RATIOS
■
■
Gross profit margin ratio (GPMR)
Net profit margin ratio (NPMR)
■
03/24
R
/14 eturn on investment
• Profitability ratios indicate
•Company's profitability in relation to other
companies
• Internal comparison with last yrs profits
•Managements effectiveness as shown by returns
generated on sales and investments

28. GROSS PROFIT MARGIN RATIO
(GPMR)
■ Represents cost of production
Helps in understanding proportion of raw materials used
and direct expenses incurred in overall production process
Reflects income being generated which can be
apportioned by promoters
■ Reflects efficiency of firm’s operations as well as how
products are priced
■ GPMR = Gross profit/ Net sales
03/24/14 31
■
■
Net Sales
Gross Profit
GPMR
= 904
= Net sales - COGS = 904 - 714 = 190
= Gross Profit / Net sales
= 190 / 904 = 0.21 = 21%
Implies 79% (100-21%) of sales contribute towards
direct expenses and raw mtrl

29. NET PROFIT MARGIN RATIO
(NPMR)
■ Takes into account not only cost of production but also
administrative expenses like staff salary, selling &
distribution overheads
■
Net Sales = 904
■ Net profit appropriated to meet tax liability, dividend
Net Profit after taxes = 52
payments and to retain part in business
NPMR = Net Profit / Net sales
■ NPMR = Net profit (Pro=fit52af/te9r04ta=x)0/.0N5e7t=
sa5
l.
e7
s%
Implies for every Rs 100/- of sales, Rs 5.7/- earned as
profit which can be used for dividend distr and
apportioned to res & surplus
03/24/14 32
• Company B has outperformed Company A in total sales
• However A has utilized its resources more efficiently
Represents surplus of gross profit after meeting expenses
COMPANY A COMPANY B
SALES 2,00,000 2,50,000
GROSS PROFIT 40,000 40,000
NET PROFIT 20,000 22,000
GROSS PROFIT
MARGIN
20% 16%
NET PROFIT MARGIN 10% 8.8%

30. PROFITABILITY IN RELATION TO INVESTMENT-
RETURN ON INVESTMENT (ROI)
■ Indicates efficiency with which company used its Capital
(Equity as well as debt)
Takes into account overall returns of the company
assuming company has not taken any debt
■ Gives overall returns including adjustments of earnings
for fin leveraging
■ Enables one to check whether return made on investment
is better than other alternatives available
■ Suited for inter-firm comparisons
■ ROI = EBIT x100 / Capital employed
03/24/14 33
■
•
•
•
•
EBIT = 143
Capital employed = 566 ( (120+50+215+181)-(0+0) )
(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets +
Non operating investments)
ROI = 143/566 x 100 = 25.26 %.
The company has earned a profit of 25.26 paise on
every 100 Re invested

31. CLASSIFICATION OF RATIOS
34
■ Liquidity ratios
■ Leverage / Solvency ratios
■ Turnover / Activity ratios
■ Profitability ratios
➔ Valuation ratios

32. VALUATION RATIOS
35
■ Earning per share (EPS)
Price Earnings (PE) Multiple
Price Earnings Growth (PEG) Multiple
Dividend Payout Ratio
Dividend Yield
Beta of Stock
■
■
■
■
■

33. EARNINGS PER SHARE
(EPS)
03/24/14 36
■ Represents total earnings of a company available for
distribution among equity shareholders
Evaluates performance of company shares over a period of
time
EPS = Net profit available for equity shareholders / No of
Equity shares
EPS alone should not be basis of decision making with
respect to purchase of any company share
Faulty reasons of High EPS
■
■
■
■
■ Less No of Equity shares
Investment in risky ventures
■

34. PRICE EARNING (PE) MULTIPLE
37
■ Simplest method of comparing different stocks at a point
of time to make investment decisions
As a layman, this is the price being paid for buying one
rupee of earning of a company eg If PE of Infosys share is
Rs 9/- it means we are paying to the market a price of 9
for every Rs 1/- earning of the company
PE Ratio = Market Price per share/ EPS
■
■

35. PRICE EARNING GROWTH (PEG)
MULTIPLE
■ An extension of PE which also takes into account growth
rate of the company
PEG Multiple = PE / Growth
■
COMPANY COMPANY Analysis
A B
Market Price 200 200
EPS 10 20
Growth rate 5% 2%
PE Multiple 20 (200/10) 10 (100/20) A overvalued
PEG Multiple 4 (20/5) 5 (10/2) B overpriced wrt
growth potential
Which company stocks to be purchased ?
38

36. DIVIDEND PAYOUT RATIO
39
■ Shows amount of dividend paid out of earnings
An indication of amount of profits put back into company
Imp ratio to assess long term prospects of company
Dividend Payout Ratio = Dividend / Net Income
■
■
■

37. DIVIDEND YIELD
■ Shows relationship between Dividend per share and
market price
An imp ratio to compare two companies
Dividend Yield (%) = Dividend amount per share *100
■
■
Market price of share
03/24/14 40

38. BETA OF SECURITY
41
■ Refers to overall market risk which a security is carrying
and which cannot be diversified
Responsiveness of share price of a company with respect
to overall market movement
If over a period of time, market has given a return of 20%;
individual share of company ‘A’ has given return of 10%;
Beta of A= 10 / 20 = 0.5
If investor is risk averse, should invest in stocks with low
Beta; Even if market falls by drastic amount his investment
will not take that much hit
■
■
■

39. 42
FINANCIAL RATIOS
PR
.
OFITABILITY
LIQUIDITY
NWC = CA - CL
CR = CA/CL
ATR = (CA –INVENTORY)/CL
LEVERAGE
Debt-Equity Ratio
Liab Coverage Ratio =
= Debt/Net Worth
Int gen funds / Total
Debt/Total
EBIT/Debt
Liab Debt to Assets Ratio =
Assets Interest Coverage Ratio =
Interest
ACTIVITY/TURNOVER
Inventory Turn Over Ratio
FATR
Assets
Avg Collection Period
= Net Sales/Inventory
= Net Sales/Total
= 365/ RTOR
GPMR
NPMR
ROI
Capital
= Gross Profit/Net Sales
= Net Profit/Net Sales
= EBIT x 100/
= Equity earnings/
Solvency , Safety
Margins,
Idle Resources , Risk
Long term solvency
Risk due to debt
Owners Stake
Coverage provided
by assets
Interest burden
Utilisation
Credit mgt
Restrictions
Efficency
Efficency
Acceptability
Overall performance
Margin of Safety
Ability for PAT