 Is a method or process by which the

relationship of items or groups of items in

the financial statements are computed, and
presented.
 Is an important tool of financial analysis.
 Is used to interpret the financial statements
so that the strengths and weaknesses of a
firm, its historical performance and current
financial condition can be determined.
‘A mathematical yardstick that
measures the relationship
between two figures or groups
of figures which are related to
each other and are mutually
inter-dependent’.
It can be expressed as a pure
ratio, percentage, or as a rate
Ratios can be broadly classified into four
groups namely:
 Liquidity ratios
 Capital structure/leverage ratios
 Profitability ratios
 Activity ratios
 These ratios analyse the short-term
financial position of a firm and indicate the
ability of the firm to meet its short-term
commitments (current liabilities) out of its
short-term resources (current assets).
These are also known as ‘solvency ratios’.
The ratios which indicate the liquidity of a
firm are:
 Current ratio
 Liquidity ratio or Quick ratio or acid test
ratio
It is calculated by dividing current assets by current
liabilities.
Current ratio = Current assets where
Current liabilities
Conventionally a current ratio of 2:1 is considered
satisfactory
include –
Inventories of raw material, WIP, finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank,
prepaid expenses,
incomes receivables and
marketable investments and short term securities.
include –
sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received,
incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12
months,
bank overdraft and cash credit
This is a ratio between quick current assets
and current liabilities (alternatively quick
liabilities).
It is calculated by dividing quick current assets
by current liabilities (quick current
liabilities)
Quick ratio = quick assets
where
Current liabilities/(quick
liabilities)

Conventionally a quick ratio of 1:1 is

considered satisfactory.
QUICK ASSETS are current assets (as stated
earlier)
less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as

stated earlier)
less bank overdraft and incomes received in
advance.
 These ratios indicate the long term
solvency of a firm and indicate the ability
of the firm to meet its long-term
commitment with respect to
(i) repayment of principal on maturity or in
predetermined instalments at due dates
and
(ii) periodic payment of interest during the
period of the loan.
The different ratios are:
 Debt equity ratio
 Proprietary ratio
 Debt to total capital ratio
 Interest coverage ratio
 Debt service coverage ratio
This ratio indicates the relative proportion of
debt and equity in financing the assets of the
firm. It is calculated by dividing long-term debt
by shareholder’s funds.
Debt equity ratio = long-term debts
where
Shareholders funds
Generally, financial institutions favour a ratio
of 2:1.

However this standard should be applied having

regard to size and type and nature of business and
the degree of risk involved.
LONG-TERM FUNDS are long-term loans
whether secured or unsecured like –
debentures, bonds, loans from financial
institutions etc.

SHAREHOLDER’S FUNDS are equity share

capital plus preference share capital plus
reserves and surplus minus fictitious assets
(eg. Preliminary expenses, past
accumulated losses, discount on issue of
shares etc.)
This ratio indicates the general financial
strength of the firm and the long- term
solvency of the business.
This ratio is calculated by dividing
proprietor’s funds by total funds.
Proprietary ratio = proprietor’s funds
where
Total funds/assets
As a rough guide a 65% to 75%
proprietary ratio is advisable
PROPRIETOR’S FUNDS are same as explained
in shareholder’s funds

TOTAL FUNDS are all fixed assets and all

current assets.
Alternatively it can be calculated as
proprietor’s funds plus long-term funds plus
current liabilities.
In this ratio the outside liabilities are related
to the total capitalisation of the firm. It
indicates what proportion of the permanent
capital of the firm is in the form of long-term
debt.
Debt to total capital ratio =long- term debt

Shareholder’s funds + long-

term debt
Conventionally a ratio of 2/3 is considered
satisfactory.
This ratio measures the debt servicing capacity of
a firm in so far as the fixed interest on long-term
loan is concerned. It shows how many times the
interest charges are covered by EBIT out of which
they will be paid.
Interest coverage ratio = EBIT
Interest
A ratio of 6 to 7 times is considered
satisfactory. Higher the ratio greater the ability
of the firm to pay interest out of its profits. But
too high a ratio may imply lesser use of debt
and/or very efficient operations
This is a more comprehensive measure to
compute the debt servicing capacity of a firm. It
shows how many times the total debt service
obligations consisting of interest and repayment
of principal in instalments are covered by the
total operating funds after payment of tax.
Debt service coverage ratio =
EAT+ interest + depreciation + other non-
cash exp
Interest + principal
instalment
EAT is earnings after tax.
Generally financial institutions consider 2:1 as
a satisfactory ratio.
These ratios measure the operating efficiency of the
firm and its ability to ensure adequate returns to its
shareholders.
The profitability of a firm can be measured by its
profitability ratios.

Further the profitability ratios can be determined (i)

in relation to sales and
(ii) in relation to investments
Profitability ratios in relation to sales:
 gross profit margin
 Net profit margin
 Expenses ratio
Profitability ratios in relation to investments
 Return on assets (ROA)
 Return on capital employed (ROCE)
 Return on shareholder’s equity (ROE)
 Earnings per share (EPS)
 Dividend per share (DPS)
 Dividend payout ratio (D/P)
 Price earning ratio (P/E)
This ratio is calculated by dividing gross profit by
sales. It is expressed as a percentage.

Gross profit is the result of relationship between

prices, sales volume and costs.
Gross profit margin = gross profit x 100
Net sales
A firm should have a reasonable gross profit
margin to ensure coverage of its operating
expenses and ensure adequate return to the
owners of the business ie. the shareholders.
 To judge whether the ratio is satisfactory or
not, it should be compared with the firm’s
past ratios or with the ratio of similar firms
in the same industry or with the industry
average.
This ratio is calculated by dividing net profit by sales.
It is expressed as a percentage.
This ratio is indicative of the firm’s ability to leave a
margin of reasonable compensation to the owners for
providing capital, after meeting the cost of
production, operating charges and the cost of
borrowed funds.
Net profit margin =
net profit after interest and
tax x 100
Net sales
Another variant of net profit margin is
operating profit margin which is calculated as:
Operating profit margin =
net profit before interest and tax x
100
Net sales
Higher the ratio, greater is the capacity of the
firm to withstand adverse economic conditions
and vice versa
These ratios are calculated by dividing the various
expenses by sales. The variants of expenses ratios are:
Material consumed ratio = Material consumed x
100
Net sales
Manufacturing expenses ratio = manufacturing
expenses x 100
Net sales
Administration expenses ratio = administration expenses
x 100
Net sales
Selling expenses ratio = Selling expenses x 100
Net sales
Operating ratio = cost of goods sold plus operating
expenses x 100
Net sales
Financial expense ratio = financial expenses x 100
Net sales
The expenses ratios should be compared over
a period of time with the industry average as
well as with the ratios of firms of similar
type. A low expenses ratio is favourable.
The implication of a high ratio is that only a
small percentage share of sales is available
for meeting financial liabilities like interest,
tax, dividend etc.
This ratio measures the profitability of the
total funds of a firm. It measures the
relationship between net profits and total
assets. The objective is to find out how
efficiently the total assets have been used by
the management.
Return on assets =
net profit after taxes plus
interest x 100
Total assets
Total assets exclude fictitious assets. As the
total assets at the beginning of the year and
end of the year may not be the same, average
total assets may be used as the denominator.
This ratio measures the relationship between net profit
and capital employed. It indicates how efficiently the
long-term funds of owners and creditors are being used.
Return on capital employed =
net profit after taxes plus
interest x 100
Capital employed
CAPITAL EMPLOYED denotes shareholders funds and long-
term borrowings.
To have a fair representation of the capital employed,
average capital employed may be used as the
denominator.
This ratio measures the relationship of profits to
owner’s funds. Shareholders fall into two groups i.e.
preference shareholders and equity shareholders. So
the variants of return on shareholders equity are

Return on total shareholder’s equity =

net profits after taxes x 100
Total shareholders equity
.
 TOTAL SHAREHOLDER’S EQUITY includes
preference share capital plus equity share
capital plus reserves and surplus less
accumulated losses and fictitious assets. To
have a fair representation of the total
shareholders funds, average total
shareholders funds may be used as the
denominator
Return on ordinary shareholders equity =
net profit after taxes – pref. dividend x 100
Ordinary shareholders equity or
net worth
ORDINARY SHAREHOLDERS EQUITY OR NET
WORTH includes equity share capital plus
reserves and surplus minus fictitious assets.
This ratio measures the profit available to the
equity shareholders on a per share basis. This
ratio is calculated by dividing net profit
available to equity shareholders by the number
of equity shares.
Earnings per share =
net profit after tax – preference
dividend
Number of equity shares
This ratio shows the dividend paid to the
shareholder on a per share basis. This is a
better indicator than the EPS as it shows the
amount of dividend received by the ordinary
shareholders, while EPS merely shows
theoretically how much belongs to the ordinary
shareholders
Dividend per share =
Dividend paid to ordinary
shareholders
Number of equity shares
This ratio measures the relationship between
the earnings belonging to the ordinary
shareholders and the dividend paid to them.
Dividend pay out ratio =
total dividend paid to ordinary
shareholders x 100

Net profit after tax –preference dividend

OR
Dividend pay out ratio = Dividend per share x
100
Earnings per share
This ratio is computed by dividing the market price of
the shares by the earnings per share. It measures the
expectations of the investors and market appraisal of
the performance of the firm.
Price earning ratio = market price per share
Earnings per share
 These ratios are also called efficiency ratios /
asset utilization ratios or turnover ratios.
These ratios show the relationship between
sales and various assets of a firm. The various
ratios under this group are:
 Inventory/stock turnover ratio
 Debtors turnover ratio and average collection
period
 Asset turnover ratio
 Creditors turnover ratio and average credit period
This ratio indicates the number of times inventory is
replaced during the year. It measures the
relationship between cost of goods sold and the
inventory level. There are two approaches for
calculating this ratio, namely:
Inventory turnover ratio = cost of goods sold
Average stock
AVERAGE STOCK can be calculated as
Opening stock + closing
stock
2
Alternatively
Inventory turnover ratio = sales_________
Closing inventory
A firm should have neither too high nor too
low inventory turnover ratio. Too high a
ratio may indicate very low level of inventory
and a danger of being out of stock and
incurring high ‘stock out cost’. On the
contrary too low a ratio is indicative of
excessive inventory entailing excessive
carrying cost.
This ratio is a test of the liquidity of the debtors of a
firm. It shows the relationship between credit sales
and debtors.
Debtors turnover ratio =
Credit sales
Average Debtors and bills receivables
Average collection period =
Months/days in a year
Debtors turnover
These ratios are indicative of the efficiency
of the trade credit management. A high
turnover ratio and shorter collection period
indicate prompt payment by the debtor. On
the contrary low turnover ratio and longer
collection period indicates delayed payments
by the debtor.
In general a high debtor turnover ratio
and short collection period is preferable.
Depending on the different concepts of assets employed,
there are
many variants of this ratio. These ratios measure the
efficiency of a firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold
Average total assets
Fixed asset turnover ratio = sales/cost of goods sold
Average fixed assets
Capital turnover ratio = sales/cost of goods sold
Average capital employed
Working capital turnover ratio = sales/cost of goods sold
Net working capital
Higher ratios are indicative of efficient
management and utilisation of resources
while low ratios are indicative of under-
utilisation of resources and presence of idle
capacity.
This ratio shows the speed with which payments are
made to the suppliers for purchases made from them.
It shows the relationship between credit purchases
and average creditors.
Creditors turnover ratio =
credit purchases
Average creditors & bills payables
Average credit period = months/days in a year
Creditors turnover ratio
Higher creditors turnover ratio and short
credit period signifies that the creditors are
being paid promptly and it enhances the
creditworthiness of the firm.
 Financial Ratio Analysis
Financial analysis: Applying analytical techniques to financial statements and
other relevant data to produce information useful for
decision making.
Focus

Three Issues : Profitability, Liquidity, Safety (Solvency or Risk)

In general, each financial ratio is closely related to one of the three

fundamental issues.

This analysis is intended as a background review. See also “Merrill Lynch How
to Read A Financial Statement” which is available on the web.
ABC Company Balance Sheet December 31
Current Assets: Year 1 (Current year) Year 2 (Last year)
Cash and cash equivalents $ 50,000 $ 35,000
Trading securities (at fair value) 750,000 65,000
Accounts receivable 300,000 290,000
Inventory (at lower of cost or market) 290,000 275,000
Total current assets 715,000 665,000
Investments available-for-sale (at fair value) 350,000 300,000
Fixed Assets:
Property, plant, and equipment (at cost) 1,900,000 1,800,000
Less: Accumulated depreciation (380,000) (350,000)
1,520,000 1,450,000
Goodwill 30,000 35,000
Total assets $2,615,000 $2,450,000
Current Liabilities:
Accounts payable $ 150,000 $ 125,000
Notes payable 325,000 375,000
Accrued and other liabilities 220,000 200,000
Total current liabilities 695,000 700,000
Long-term debt:
Bonds and notes payable 650,000 600,000
Total liability 1,345,000 1,300,000
Stockholders’ Equity:
Common stock (100,000 shares outstanding) 500,000 500,000
Additional paid-in capital 350,000 350,000
Retained earnings 420,000 300,000
Total equity 1,270,000 1,150,000
Total liability and equity $2,615,000 $2,450,000
GI Company
Income Statement
(Year – 1)
Sales $1,800,000
Cost of goods sold (1,000,000)
Gross profit 800,000
Operating expenses (486,697)
Interest expense (10,000 )
Depreciation and Amortization expense (13,303)
Net income before income taxes 290,000
Income taxes (31%) ( 90,000)
Net income after income taxes $ 200,000

Earning per share $2

Operating cash flow $255,000
Dividends for the year $0.80 per share
Market price per share $12
 Liquidity Ratios

Working capital = Current assents – Current liabilities

Year 2: $715,000 – $695,000 = $20,000

Year 1: $665,000 – $700,000 = ($35,000)
 Liquidity Ratios

Current assets
Current ratio (working capital ratio) =
Current liabilities

$715,000
Year 2: = = 1.03
$695,000

Year 1: = $665,000 = 0.95

$700,000
(Industry average = 1.5)

The ratio, and therefore Gi’s ability to meet its short-term obligations, has
improved, though it is low compared to the industry’s average
 Liquidity Ratios

Cash equivalents + Market securities + Net receivables

Acid-test ratio =
Current liabilities

$50,000 + $75,000 + $300,000

(Year 2) = = 1.03
$695,000

(Year 1) = $35,000 + $65,000 + $290,000 = 0.95

$700,000

(Industry average = 0.80)

The industry average of .80 is higher than Gi’s ratio, which indicates that Gi
may have trouble meeting short-term needs.
 Liquidity Ratios

Cash equivalents + Marketable securities

Cash ratio =
Current liabilities

$50,000 + $75,000
(Year 2) = = 0.18
$695,000

(Year 1) = $35,000 + $65,000 = 0.14

$700,000
 Activity Ratios

Net credit sales

Accounts receivable turnover =
Gross receivables

$1,800,000
=
$300,000

= 6 times

This ratio indicates the receivables’ quality and indicates the success of the firm in
collecting outstanding receivables. Faster turnover gives credibility to the current and
acid-test ratios.
 Activity Ratios

Gross receivables
Accounts receivable turnover in days =
Net credit sales / 365

365 days
=
Receivable turnover

= 60.83days

This ratio indicates the average number of days required to collect accounts receivable.
 Activity Ratios

Cost of goods sold

Inventory turnover =
Average inventory

$1,000,000
=
$290,000

= 3.45 times

This measure of how quickly inventory is sold is an indicator of enterprise

performance. The higher of turnover, in general, the better the performance.
 Activity Ratios

Average inventory
Inventory turnover in days =
Cost of goods sold / 365

365 days
=
Inventory turnover
= 365 days
3.45
= 105.80 days

This ratio indicates the average number of days required to sell inventory.
 Activity Ratios

Operating cycle = AR turnover in days + Inventory turnover in days

= 60.83 days + 105.80 days

= 166.63 days

This operating cycle indicates the number of days between acquisition of

inventory and realization of cash from selling the inventory.
 Activity Ratios

Sales
Working capital turnover =
working capital

$1,800,000
=
$715,000 - $695,000

= 90 times

This ratio indicates how effectively working capital is used.

 Profitability Ratios

Return on total assets = Net income/Total assets

= $200,000 / $2,615,000

= 7.65%
 Profitability Ratios

Gross margin = Sales – Cost of Good Sold

= $1,800,000 - $1,000,000
= $800,000

Gross margin percentage = Gross margin / Sales

= $800,000 / $1,800,000
= 44.44%

This ratio is a good indication of how profitable a company is at the most

fundamental level. Companies with higher gross margins will have more money
left over to spend on other business operations, such as research and development
or marketing.
 Profitability Ratios

Net income
Net profit margin =
Net sales

$200,000
=
$1,800,000

= 11.11%

This ratio indicates profit rate and, when used with the asset turnover ratio,
indicates rate of return on assets, as show below.
 Profitability Ratios

Operating income
Operating margin =
Total sales

$800,000 - $486,697
=
$1,800,000

= 17.41%

Operating margin is a measurement of what proportion of a company's revenue is

left over after paying for variable costs of production such as wages, raw materials,
etc. A healthy operating margin is required for a company to be able to pay for its
fixed costs, such as interest on debt.
 Activity Ratios

Net sales
Total asset turnover =
Total assets

$1,800,000
=
$2,615,000

= 0.69 times

This ratio is an indicator of how Gi makes effective use of its assets. A high ratio
indicates effective asset use to generate sales.
 Profitability Ratios

DuPont return on assets = Net income/Total assets

Net income Net sales

x
= Net sales Total assets
= 11.11% x 0.69times

= 7.67%

Note that this ratio uses both net profit margin and the total asset turnover. This ratio
allows for increased analysis of the changes in the percentages. The net profit margin
indicates the percent return on each sale while the asset turnover indicates the effective
use of assets in generating that sale.
 Profitability Ratios

Net income + Interest expense (1- Tax rate)

Return on investment =
Long-term liabilities + Equity

$200,000 + $10,000 (1-0.31)

=
$650,000 + $1,270,000

= 0.11 times

ROI measures the performance of the firm without regard to the method
of financing.
 Profitability Ratios

Net income – Preferred dividends

Return on common equity =
common equity

$200,000 - $0
=
$1,270,000

= 15.75%
 Long-term Debt-paying Ability Ratio

Total liabilities
Debt / Equity =
Common stockholders’ equity

(Year 2) = $1,345,000 / $1,270,000 = 1.06

(Year 1) = $1,300,000 / $1,150,000 = 1.13

This ratio indicates the degree of protection to creditors in case of insolvency. The
lower this ratio the better the company’s position. In Gi’s case, the ratio is very high,
indicating that a majority of funds come from creditors. However, the ratio is
improving.
 Long-term Debt-paying Ability Ratio

Total liabilities
Debt ratio =
Total assets

(Year 2) = $1,345,000 / $2,615,000 = 51.4%

(Year 1) = $1,300,000 / $2,450,000 = 53.1%

This ratio indicates that more than half of the assets are financed by creditors.
 Long-term Debt-paying Ability Ratio

Returning income before taxes and interest

Times interest earned =
Interest

$290,000 + $10,000
=
$10,000

= 30 times

This ratio reflects the ability of a company to cover interest charges. It uses income
before interest and taxes to reflect the amount of income available to cover interest
expense.
 Long-term Debt-paying Ability Ratio

Operating cash flow

Operating cash flow / Total debt =
Total debt

$255,000
=
$1,345,000

= 18.96%

This ratio indicates the ability of the company to cover total debt with yearly cash
flow.
 Liquidity Ratios

Cash from operations

The operating cash flow ratio =
Current liabilities

$255,000
=
$700,000

= 0.36
The purpose of this ratio is to assess whether or not a company's operations are
generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00,
then the company is not generating enough cash to meet its current commitments.
Note: The cash from operating activities is $255,000 shown at the bottom of the
income statement.
 Profitability Ratio

EBIT = Earnings + Interest Expense + Tax Expense

= $200,000 + $10,000 + $90,000

= $300,000

A measure of a company's earning power from ongoing operations, equal to

earnings before deduction of interest payments and income taxes. EBIT excludes
income and expenditure from unusual, non-recurring or discontinued activities.
 Profitability Ratio

EBITDA = Earnings + Interest Expense + Tax Expense +

Depreciation + Amortization

= $200,000 + $10,000 + $90,000 + $13,303

= $ 313,303

This earnings measure is of particular interest in cases where companies have large
amounts of fixed assets which are subject to heavy depreciation charges or in the
case where a company has a large amount of acquired intangible assets on its books
and is thus subject to large amortization charges. Since the distortionary accounting
and financing effects on company earnings do not factor into EBITDA, it is a good
way of comparing companies within and across industries.