A) ACTIVITY RATIOS/ TURN OVER RATIOS

(Measuring liquidity indirectly)

a) Inventory T.O. ratio = COGS/Avg. Inventory (higher the better; this figure is used for
calculating DIO)
Avg. Inventory = Opening inventory (previous year’s closing stock) plus closing inventory of the
current year divided by two
COGS can be direct production cost (Investopedia, 2007) or the total cost except interest and taxes
(ICFAI, 2005)
b) Credit T.O. ratio or A/C receivables T.O. ratio = Net Credit Sales (total credit sales- cost
of goods returned) / Avg. A/c Receivables (higher the better; this figure is used for
calculating DSO)
c) Cash T.O. ratio or A/C receivables T.O. ratio = Net Cash Sales (total cash sales- cost of
goods returned) / Avg. A/c Receivables (higher the better; this figure is used for calculating
DSO)
d) Net Credit Sales / Net Cash Sales

e) A/c payables T.O. ratio = Net Debit Sales / Avg. A/c Payables
Net Debit Sales = Net Cash Sales (total cash sales – cogr) –Net Credit Sales

f) Working capital T.O. ratio = COGS / Avg. Working Capital

*Working Capital falls on the credit side of the balance sheet under ‘Application of Funds’ in contrast
to the ‘Sources of Funds’ on the debit side; W.C. constitutes CA + CL + Provisions

A typical Balance Sheet (tallying C+L =A) has two sides:

The credit side (total assets) called ‘Application of Funds’ consists of Net Block (gross block--accum.
depreciation), Capital Work-in-Progress, Investments, Net Current Assets or Net W.C. (CA -- CL +
Provision) and Misc. Expenses not w/o
Net block + CWIP+ Invt.+ Misc. Expenses not w/o = Fixed assets (PPE)
The debit side (total liabilities = C+L) called the ‘Sources of Funds’= Total Shareholder’s Funds
(share capital+ total reserves) Plus Total Debt (secured and unsecured loans)
However,
Book value= Net worth (paid up capital or paid equity capital + reserves + surplus) or Book
value of Assets - Book value of Liabilities

1
B) LIQUIDITY MEASUREMENT RATIOS (reference:
Investopedia, 2007)

a)

Current assets= cash and equivalents+ Short-term investments+ A/C receivables + Deferred and
Advanced Payments+ Current Inventories (raw materials+ stock/work in progress+ finished items)
Investopedia, 2007

Another variant:
Current assets: cash and bank balances+ loans, advances and deposits +sundry debtors (A/c
receivables from the buyers incl. those who have the credit for than six months -- prov. for doubtful
debts) + deferred and advanced payments+ inventories (raw materials+ stock/work in progress+
finished items) (ICFAI, 2005)

Current Liabilities = Short term debt+ current portion of the long term debt+ operation liabilities such
as tax payment, electricity bill payment , A/c payables to the suppliers.

b)

Another variant:
Quick ratio=Quick assets /Quick liabilities
Quick liabilities= CL-- Bank overdrafts -- income received in advance

c)
Bank Finance to working capital gap ratio = short term bank borrowings / working capital gap

Working capital gap =CA less CL other than bank borrowings

d)

2
e)

DIO =Average inventory/cost of sales per day e.g. 700/365

DSO= Average accounts receivable / net sales per day
DPO = Average accounts payable/cost of sales per day

Alternative ways for calculating DIO and DSO:

Avg. Period = 360 or 365(US) / Inventory T.O. ratio figure
Avg. Collection Period = 360 or 365(US) / A/C receivables T.O. ratio figure

3
C) PROFITABILITY or EFFICIENCY INDICATOR RATIOS
PROFIT MARGIN ANALYSIS RATIOS
a)

Gross Profit= Net Sales (Sales T.O. – COGR & Excise Duty) – COGS (direct production cost = labor
+ materials + operational heads related to marketing); first level profit

Main constituents of INCOME according to a typical P&L Account

Total Income= Sales T.O. + Other Income+ Stock Adjustments (closing stock of finished goods+
closing stock of work-in-progress+ closing stock of other material—opening stock of finished goods +
opening stock of work-in-progress+ opening stock of other material )
Main constituents of EXPENDITURE include
(direct production cost = Raw materials + Power & Fuel Cost+ Employees Cost + Other
Manufacturing Expenses + Excise Duty ) + (operating expenses = S&GA+ R&D+ Depreciation +
Amortization+ Miscel. Expenses )+ Interest + Corporate Taxes
After subtracting Total COGS from Total Income, the P&L account also makes ‘adjustments for net
profit’ (such as extraordinary incomes from sale of assets, accruals due to change in accounting
policies etc that are added to the Net Profit) +P&L balances b/fwd -- Appropriations (to gen. reserves
and prov. for dividends and redemption of debentures) and finally the P&L balance is carried down

b)

Operating Profit = Gross profit— (operating expenses = S& GA+ R&D+ Dep. + Amort.); second
level profit also called EBIT

c)

Pretax Profit is same as PBT or EBT = EBIT or Operating Profit – Interest (payments on fixed
instruments and community interest); third level profit
d)

4
Net Income or Net Profit is PAT
PAT = EBIT—Taxes
Further appropriations are made from Net Income (to general reserves, provisions for dividends and
debenture redemption reserves); interest to preference shareholders is also paid from PAT only but
before dividends to equity shareholders.

e)
Effective Tax Rates:

Pretax income= EBT or PBT

Profit margin analysis ratios are calculated on the basis of net sales, while rate of return ratios are
calculated on the basis of assets and capital. For overall profitability (efficiency) analysis of a firm
both set of ratios must be collated and mutually assayed. as a firm might do well on the latter but may
not do equally better on the former.

RATE OF RETURN RATIOS

f)
Net Income
Return on Assets = --------------------
Average Total Assets
Variants: Returns are also calculated sometimes on Sales T.O. , Net Sales, EBIT or Total income than
PAT
Net Sales /Avg. Total Assets is called the Avg. Asset T.O. ratio , while EBIT/Avg. Total Assets is
supposed to be an important measure of the ‘Earning Power’ or ‘Operating
Profitability/Efficiency’ of a firm free of the effects of interest and tax rates
Average total assets = Opening stock of assets (previous year’s closing stock of assets) plus closing
stock of assets of the current year divided by two.

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For calculating total assets consider all the constituents of the ‘application of funds’ on the credit side
of the balance sheet and do not subtract current liabilities and provisions from the current assets. The
CL and provisions otherwise stand deducted from current assets in the usual format (ICFAI, 2005)

DU PONT ANALYSIS:
Net Income/ Net Sales
Return on Assets = --------------------------------------
Average Total Assets /Net Sales

ROA = Net Profit Margin * Average Asset T.O. Ratio

NPM= Net Income / Net Sales whereas,
Net Income = Net Sales – Total expenses and
Avg. Asset T.O. Ratio = Net Sales / Average Total Assets whereas,
Average Total Assets = Avg. Current Assets + Avg. Fixed Assets

Note: A further ‘common size analysis’ can provide deeper clues to managing each component.

g)

Net Income
Return on Equity = -----------------------
Avg. Shareholder’s Equity
Avg. Shareholder’s Equity = Total Shareholders’ Fund (share capital + total reserves) of the current
and the preceding year as reported in the balance sheet / 2

DU PONT ANALYSIS:

Net Income
Return on Equity = --------------------
Avg. Shareholder’s Equity

ROE = Net Profit / Net Sales * Net Sales / Avg. Assets * Avg. Assets / Avg. Shareholder’s Equity
Avg. Assets / Avg. Equity = Equity multiplier
Avg.Assets 1 1
= -------------------------------- = ------------------------------------------- = -----------------------------
Avg. Assets – Avg. Debt 1 ---- ( Avg. Debt / Avg. Assets) 1—(Debt to Asset Ratio)

6
h)
Return on Net Worth (RONW) = Net Income / Net Worth
Net worth = paid up capital or paid equity capital + reserves + surplus

i)

Average Debt Liabilities = Avg. short term and long-term borrowings of two consecutive years

7
D) OPERATING PERFORMANCE RATIOS

Fixed Asset T.O. Ratio = Revenue

-------------------------------------
PPE (Avg. of year end assets of the preceding and the current year)

Revenue = Net sales

.
b) Sales /Revenue per employee = Revenue
----------------------------------------
Number of employees (Avg. as reported in the annual report)

Variations:
Avg. earnings per employee ratio could also be calculated using net income (as opposed to net sales)
in the numerator.

c)

Operating Cycle (days) = DIO+DSO-- DPO

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E) KEY DEBT/ LEVERAGE RATIOS
(to judge long term solvency; further divided into ‘capital structure’ and ‘coverage’ ratios)
(Reference: Investopedia, 2007)

CAPITAL STRUCTURE RATIOS:

a) Debt Ratio = Total Liabilities (operational and external liabilities*) / Total Assets
Total Liabilities= All debts and loans from the debit side of the balance sheet + the current liabilities and
provisions shown on the credit side (there are low, moderate and conservative versions of total liabilities).
It indicates how much % of the total assets is financed through debt.
b) Debt-Equity Ratio = Total Liabilities /Shareholders’ equity shares*

Equity = Net worth+ preference shares not redeemable in one year

It shows off the proportion of the liability component namely, the sources of funds. The range varies from
1.5 – 3: 1

Commentary:
Both a) and b) can be higher for a high leverage company. It’s definitely indicative of the financial prowess of a
company. However, increasing debt component in the long run affects long- term earnings and net income. The
two also measure the financial risk; the risk of a company to attract further external and internal funds.

c) Capitalization Ratio = Long term debt / Long term debt + Shareholders’ equity shares

Commentary:
It can be higher for a high leverage company. It is also indicative of the debt churning capacity of a company.

COVERAGE RATIOS:

Funds available to meet an obligation

------------------------------------------------
Amount of that obligation

d) Interest Coverage Ratio in % terms = Earnings before interest and taxes (EBIT)*/ interest paid *100
* The amt. of depreciation is already factored in EBIT
Commentary:
A higher interest coverage ratio shows off a consistently better debt servicing quality on part of a company.
Hence, the company is likely to attract more debt subsequently, resulting into a high leverage organization.

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Companies like IBM and Intel attract more debt than many medium sized firms on account of their better
interest coverage ratio.

e) Fixed Charges Coverage Ratio =

Earnings before depreciation, debt interest, lease rentals and taxes

--------------------------------------------------------------------------------------------------------
Debt interest+ Lease rentals + Loan repayment installment + preference dividends
------------------------------------ ---------------------------
(1—tax rate) (1—tax rate)
This ratio addresses all fixed charges (fixed fin. obligations) as mentioned in the denominator. As these charges
are not tax deductible they have to be tax adjusted. The ‘loan repayment installment’ and ‘preference dividends’
are assumed and divided up accordingly.

f) Debt Service Coverage ratio

PAT+ Depreciation+ Other non-cash charges + Interest on term loan
----------------------------------------------------------------------------------------
Interest on term loan + Repayment of the term loan
Note: It is normally used by term lending FIs in India. The ratio indicates how many times are the post-tax
earnings to total obligation (interest and loan repayment)

g) Cash Flow to Debt Ratio = Operating cash flow / Total Debt

Variations:
A more conservative cash flow figure calculation in the numerator would use a company's free cash
flow (operating cash flow minus the amount of cash used for capital expenditures). A more
conservative total debt figure would include, in addition to short-term borrowings, current portion of
long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-
cancelable operating leases.

Commentary:
A higher debt to cash ratio percentage indicates an ample capacity of a company to borrow a
significant amount of money, if it chooses to do so.

F) KEY CASH FLOW INDICATOR RATIOS:

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a)

b)

CASH COVERAGE RATIOS:

c)

d)

e)

f)

g)

Commentary:
The operating cash flow figure is the foremost source of a company's cash generation (which is
internally generated by its operating activities). The greater the amount of operating cash flow, the
better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability
to generate consistent and/or improving percentage comparisons are positive investment qualities.

Note: Instead of Dividend pay-put ratio, ‘Dividend Coverage Ratio’ is in vogue in the U.K. This is
equal to EPS/Dividend per common share.

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N.B. A further ‘Comparative Analysis’ can be conducted using ratio analysis data such as-
1-Cross sectional analysis
2- Time series analysis
a- Y2Y change
b-Index analysis
3-Common-size analysis: Set total assets and total liabilities each at 100 and express every item on the
balance sheet in % terms on the given base. Similarly, Net Sales can be set at 100 in the income
statement.

G) INVESTMENT VALUATION RATIOS

(From the owners’ and the potential investors’ perspective)

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a) EPS = PAT / Number of Equity Shares Outstanding
Variants: Basic EPS and Diluted EPS
Under diluted EPS the hybrid shares are also considered such as fully or partially convertible
warrants, notes, preference shares and debentures into equity shares; it’s a more conservative and
pessimistic assessment
PAT can also vary as it may be based upon past twelve months data (trailing P/E) or next twelve
months data (estimated P/E) or both (value line research, S&P, Moody research)
Expected EPS = Expected PAT-- Preference Dividend / Number of Equity Shares Outstanding
Note: Since EPS is the basis for deciding the dividend payout ratio hence, for a healthy EPS, there
must be a proportionate increase in net income with the increase in no. of shareholders; dividend is
paid as a percentage of EPS

Book Value per share

Book value = Net worth (paid up capital or paid equity capital + reserves + surplus) /Total no. of
equity shares outstanding as reported in the balance sheet towards the fiscal year end

Liquidation Value per share

Value post liquidation of all assets – Amt. payable to all credit holders and preference shareholders /
Number of Equity Shares Outstanding

b) P/E ratio = Market price of stock (share price) / EPS (Fundamental Analysis tools)
Intrinsic value of a share = Expected EPS * Appropriate P/E ratio; P/E ratio determines the expected
market value of a stock. For the same EPS of two firms, a higher P/E ratio means higher intrinsic and
expected value.
P/E itself is based on many parameters:
Growth rate (historical or expected earnings) of a firm resulting in the ‘ Growth Rate of Dividends’,
Stability and predictability of earnings and other projections, Dividend pay-out ratio (historical and
potential), Size of a firm, and the Quality of management (EBIT/Avg.Total Assets, CCC or Operating
Cycle ratio). The higher are these parameters, the higher is the P/E ratio.

Impact of Growth on Price (P0), Dividend Yield, Cap. Gain and P/E ratio

Price Dividend Capital gain yield P/E

13
 Yield (rate of P1—P0 / P0 EPS =
return) Rs. 5
D1 / P0*100
Case 1 4/25 = 16 % 0% 5
No growth firm; zero growth rate in dividends Or
(Neutral growth stocks/Firms with a stable rate of
return /Constant dividends @ zero %)
P0 = D1 / r (req. rate of return in %) – g (growth rate
%)
4 / .16-- zero = Rs 25

Case 2 4/40 = 10% 60 % 8

Normal /Perpetual growth firm; e.g. 6% growth rate
(Growth of the dividends at a constant compound
rate)
D1 = D0 (1+ g) t
D1= Div. for year 1 ; D0 = For year 0 ; g
= Const. compound growth rate
P0 = D1/(1+r) + D1(1+g)/(1+r)2 + D1(1+g)2 /
(1+r)3 + ---- or
*P0 = D1 / r – g = Rs 40

Case 3 4/67 = 6% 67.5 % 13.4

Super normal growth; @ 10 % and above
P0 = Rs 67
Case 4
Valuation with variable growth in dividends

c) Capitalization Rate = EPS / Market Price Per Share

(The reciprocal of P/E ratio)

Price Dividend Capital P/E EPS/P0 D1/EPS %

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 Yield gain EPS = (Capitalization Dividend
D1 / P0*100 yield Rs. 5 rate/Earning payout ratio
P1--P0 / yield/ required
P0 rate of return
%)
Case 1 4/25 = 16 % 0% 5 5/25 =20% 4/5 = 80%
No growth firm;
zero growth rate
P0 = D1 / r (req. rate
of return in % terms)
– g (growth rate in
% terms)
4 / .16-- zero = Rs
25

Case 2 4/40 = 10% 60 % 8 12.5% 80%

Normal growth firm;
6% growth rate
P0 = D1 / r – g = Rs
40

Case 3 4/67 = 6% 67.5% 13.4 7.46% 80%

Meta normal growth;
@ 10 %
P0 = Rs 67

Increase in the dividend amount and/or dividend growth rate → increase in share price → increase in
P/E ratio and subsequent decrease in capitalization rate (the reciprocal of P/E ratio). An increasing P/E
ratio means that an investor ends up investing more dollars per share for earning every dollar amount
per share (EPS) and the resulting capitalization rate means that the firm is therefore required or
expected to earn as much percent on the common stock value.
A lower Cap. rate implies a high price security which could fetch though a low ‘Dividend Yield’ but a

high ‘Capital gain yield’ (HPY= It + Ct / P; estimated/actual yield or returns on

investments).This is preferred by ‘growth investors’ (case 2 & 3) but those who seek high
dividend yield would prefer ‘neutral growth stocks’ (case 1).
The Formula Source as based on different approaches to stock evaluation:

15
*P0 = D1 / r (req. rate of return in % terms) – g (growth rate in % terms)
Growth Value model for ascertaining share price; derived from the PV/Div. Cap. model

Present Value Approach/Dividend Capitalization Approach to Stock Valuation:

r = D1 / P 0 + P1- P0 /P0
Here ‘r’ is dividend yield which serves as the rate of return. It’s a composite of div. yield and capital
gain yield.
P0 = D1 + P1/ 1+ r for one year holding period ; D1 is expected div. a year hence after the
share is bought , P1 is exp. price a year hence
P0 = ∑ Dn + Pf / (1+ r) n for multiple year holding period (finite duration)
P0 = ∑ Dn / (1+ r) n for multiple year holding period (infinite duration); n= 1 to infinity

d) Value Earning Ratio = Present value Per Share / EPS (Fundamental Analysis tool)

D1 (Cash Dividend) 1
= ----------------------------------- * --------------------------------
r (discount rate) -- g (growth rate) EPS

D1 (Cash Dividend) / EPS Dividend payout ratio *

= ----------------------------------- = --------------------------------
r (discount rate) -- g (growth rate) r-- g

*also known as the ‘Statistical Approach’ to stock evaluation

-V/E ratio is also known as the Expected P/E ratio; E (P/E) = PV per share / Expected EPS
Note: If P/E ratio is greater than V/E, the stock is over-priced. Value investor may sell but the growth
investor may buy. If P/E is smaller than V/E, scrip is under-priced. The value investor may buy but the
growth investor may sell. And if equal, hold / wait and watch as prices not likely to shift significantly.
There is another approach to stock valuation called ‘The Capitalization or Multiplier Approach’.
Multiplier and P/E ratio are synonymous. So Earning Multiplier = P/E ratio = Current Market
Price / Estimated Earning per Share

Risk metrics:

16
The given Cap. Rate/rate of return would serve as an objective ‘discount rate’ to
determine the present value of an instrument provided there are no # ‘systematic
(FILMI) or diversifiable (business) risks’ affecting the share price and the rate
of return.

# Risk metrics:
1-S.D = √ Variance (k); Variance = ∑ Ps (Rs – mean Rs) 2
2- Single-Index or Market Model: Rs = αs + Вs Rm + es
Where Вs = Slope reflecting change in Rs (return on security or portfolio) with a
change in Rm (return on market portfolio)
Bs = Cov (Rs Rm) / Var (Rm) = ∑ Ps (Rs – mean Rs) (Rm – mean Rm) / ∑ P (Rm –
mean Rm) 2
αs = mean Rs – Вs (mean Rm)
3- CAPM: Rs = R f + Вs (Rm – R f)
Rs = Expected or required return on security / portfolio
Rf = Risk free return
Вs (Rm – R f) = Risk premium

e-

f-

Note: It’s better than P/E as it is minus all non-cash factors

17
g-

Tangible book value is stripped of Intangible assets and goodwill

#In the denominator, the book value per share is calculated by dividing the reported
shareholders' equity (balance sheet) by the number of common shares outstanding (balance
sheet)

h-

Peg indicates a value of 1; if PEG ratio is more than 1 the scrip is overvalued/overpriced. If PEG is
less than 1 the scrip is undervalued/under-priced.

i-

Market Capitalization+ Debt+ Minority Interest

Less Cash/ Cash Equivalents
= Enterprise Value

j-

18