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Financial ratios are tools for interpreting financial statements to provide a basis for valuing
securities and appraising financial and management performance.
A good financial analyst will build in financial ratio calculations extensively in a financial
modeling exercise to enable robust analysis. Financial ratios allow a financial analyst to:
Financial ratios have been classified into five broad categories as follows:
1. LIQUIDITY RATIOS
2. LEVERAGE RATIOS
3. TURNOVER RATIOS
4. PROFITABILITY RATIOS
Liquidity Ratios:
Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick
ratio.
Current Ratio:
A very popular ratio, the current ratio is defined as:
The current ratio measures the ability of the firm to meet its current liabilities- currents
assets gets converted into cash during the operating cycle of the firm and provide the
funds needed to pay current liabilities. Apparently, the higher the current ratio, the
greater the short-term solvency. However, in interpreting the current ratio the
composition of current assets must not be overlooked. A firm with a high proportion of
current assets in the form of cash and debtors is more liquid than one with a high
proportion of current assets in the form of inventories even though both the firms have
the same current ratio.
Acid-test Ratio:
Also called the quick ratio, the acid-test ratio is defined as:
Cash Ratio:
Because cash and bank balances and short-term marketable securities are the most liquid
assets of a firm, financial analysts look at cash ratio, which is defined as:
Clearly, the cash ratio is perhaps the most stringent measure of liquidity.
Leverage Ratios:
Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of
finance, it is also a riskier source of finance. Leverage ratios help on assessing the risk arising
from the use of debt capital.
Two types of ratios are commonly used to analyse financial leverage: structural ratios and
coverage ratios.
Structural ratios are based on the proportions of debt and equity in the financial structure of the
firm. The important structural ratios are: debt-equity ratio and debt-assets ratio.
Coverage ratios show the relationship between debt servicing commitments and the sources for
meeting these burdens. The important coverage ratios are: interest coverage ratio, fixed charges
coverage ratio and debt service coverage ratio.
Debt-equity Ratio:
The debt-equity ratio shows the relative contributions of creditors and owners. It is
defined as:
In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by
the creditors.
Debt-asset Ratio:
The debt-asset ratio measures the extent to which borrowed funds support the firm’s
assets. It is defined as:
The ratio measures the debt servicing comprehensively because it considers both the
interest and the principal repayment obligations.
Turnover Ratios:
Turnover ratios, also referred to as activity ratios or asset management ratios, measure how
efficiently the assets are employed by a firm. These ratios are based on the relationship between
the level of activity, represented by sales or cost of goods sold, and the levels of various assets.
The important turnover ratios are: inventory turnover, debtors turnover, average collection
period, fixed assets turnover and total assets turnover.
Inventory Turnover:
The inventory turnover, or stock turnover, measures how fast the inventory is moving
through the firm and generating sales. It is defined as:
Inventory turnover = Cost of goods sold / Average inventory
The higher the ratio, the more efficient the management of inventories and vice-versa.
Debtors Turnover:
This ratio shows how many times sundry debtors (accounts receivable) turnover during
the year. It is defined as:
The higher the debtors turnover the greater the efficiency of credit management.
Average collection period = Average sundry debtors / Average daily credit sales
A high ratio indicates a high degree of efficiency in asset utilisation and a low ratio
reflects inefficient use of assets.
Profitability ratios offer several different measures of the success of the firm at generating
profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs.
Rate of return ratios reflect the relationship between profit and investment. The most important
rate of return ratios are: return on assets, earning power, return on capital employed and return
on equity.
This ratio shows the margin left meeting the manufacturing costs. It measures the
efficiency of production as well as pricing.
This ratio shows the earnings left for shareholders as a percentage of net sales.
Return On Assets:
The return on assets (ROS) is defined as:
Earning power = Profit before interest and tax / Average total assets
ROEC = Profit before interest and tax (1 – Tax rate) / Average total assets
Return On Equity:
It is defined as:
LIQUIDITY RATIOS:
Current Ratio:
It is observed from the above data that current ratio has decreased from 1.42 in the year 2007-08
to 1.14 in year 2008-09.This mean short term solvency is not satisfactory as current assets have
decline over the two years to cover the current liabilities because current ratio shows the extent
to which the current assets (easily convertible into cash) exceeds the liabilities which are shortly
payable.
Cash Ratio:
This ratio shows the immediate liquidity. It can be observed that in year 2007-08 cash ratio was
0.49 and it has slightly decreased in year 2008-09 to 0.39 which is still a satisfactory condition
because cash is the most liquid asset and are most unproductive asset of all. So company should
not maintain too much of highly super liquid assets. Cash position is satisfactory in the company.
Higher working capital ratio shows that firm has less current obligations means external equities
are lesser. So company has use less external sources. If this ratio is low, company has used more
external sources. As in the above case working capital ratio is decreasing it Means Company is
using more and more external sources of acquiring funds. Working capital ratio has decreased
from 0.34 in year 2007-08 to 0.21 in year 2008-09. So company is using its external sources well
to generate profits.
ACTIVITY RATIOS
2007-08 14.12
2008-09 18.24
It is observed that there is an increase in the fixed asset turnover ratio, i.e. in 2007-08 the ratio is
14.12 which increased in 2008-09 & reached to 18.24, which shows that there is a better
utilization of fixed asset by the company over the last years. This is as the strength of company.
Debtor turnover has increased very slightly in the year 2008-09. Higher DTR shows short
collection period and debtors are prompt in making payments. Hence company has very good
DTR, which means debtors can be quickly convertible into cash and thus, reflects the efficiency
of staff entrusted in collection of amounts due from debtors.
Capital employed ratio has slightly increased from 0.10:1 in year 2007-08 to 0.11:1 in year 2008-
09 which shows that the company is making efforts to utilize its capital efficiently.
LEVERAGE RATIOS
Debt-equity Ratio:
Debt equity ratio should neither be high nor be less. Here debt equity ratio is decreasing means
fewer borrowings are made by HDFC in the year 2008-09.Hence funds are acquired more
through equity share capital. Therefore creditors have greater margin of safety.
Since Return on assets has increased and FL ratio has also increased so it is favourable.