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Financial Ratios Glossary
Financial Ratios Glossary
FINANCIAL RATIOS
GLOSSARY
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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.
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, managements 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
10%
9%
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
100lacs
100lacs
Cost of production
60lacs
65lacs
Gross profit
40lacs
35lacs
35lacs
30lacs
5lacs
5lacs
Sales
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., nonpayment 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.
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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.
Relevant indicator/Remarks
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
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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,
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be
it
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
debts?
(-)
preference
share
capital
6. Has the companys 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
year?
loss
in
value
of
the
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debtors
in
the
year/average
(bills receivable) and average creditors creditors in the year. This should be greater
(bills payable) during the year.
acquisition of new technology, entering financial plans for the company, like whether
into
new
collaboration
agreement, they
are
coming
out
with
public
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
Is it in tradable securities or long-term
with
last
year
and
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?
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?
12. Are the companys unsecured loans Any comments to this effect in the notes to
(given) not recoverable and very old?
This
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?
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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?
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?
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?
this
has
decreased
21. What is the increase in sales income over Comparison with previous years 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
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outstanding?
23. What is the amount of work in progress Is there any comment about valuation of
as shown in the Profit and Loss Account?
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?
sheet
examination,
to
item
and
ascertain
hence
the
this
correct
comments
on
Accounting
which, there is an impact on the profits method to written down value method or
of the company?
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comments
on
Accounting
between
general
and
general expenses has increased during administrative expenses during the year and
the year under review?
29. Whether the company had sufficient Interest coverage ratio = earnings before
income to pay the interest charges?
Minimum
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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?
financial
assistance?
While
between
selling
and
Any
of
higher
commission
to
the
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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etc.}
to meet
capital.
35. Return on equity (includes reserves and Profit after tax (-) dividend on preference
surplus)
36. How much earning has our share made? Profit after tax (-) dividend on preference
(EPS)
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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?
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,
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?
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41. Has the company opened any branch Directors Report or sudden spurt in general
office in the last year?
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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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