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FINANCIAL RATIOS GLOSSARY

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Important types of ratios and their significance: ♦ Liquidity ratios ♦ Turnover ratios ♦ Profitability ratios ♦ Investment on capital/return ratios ♦ Leverage ratios ♦ Coverage ratios Liquidity ratios: o Current ratio: Formula = Current assets/Current liabilities. Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.

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this ratio would obviously be less than current ratio. this ratio is preferred. indication would either be about liquidity or profitability also. Further. depending upon the type of turn over ratio. the higher the degree of efficiency and hence these assume significance.com . turn over ratios indicate the operating efficiency. namely. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. The minimum should be 1:1. As quick assets are a part of current assets. while receivables turn over ratio would indicate the liquidity in the system. Significance = coverage of current liabilities by quick assets. unlike the other current liabilities. Turn over ratios: Generally.mbaskool. For example. Formula = Total credit sales/Average debtors http://www. as usually for an on going company. Net working capital is hence defined as medium and long-term funds invested in current assets. net working capital and bank borrowing. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity. This assumes that all other current assets like receivables can be converted into cash easily. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current liabilities the short-term bank borrowing. inventory or stocks turn over would give us a measure of the profitability of the operations. o Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to the liquidity of the system. there is no need to pay back this amount.o Acid test ratio or quick asset ratio: Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This gap is met from one of the two sources. The higher the ratio.

The production cycle and the corporate policy of keeping high stocks affect this ratio. even for a capital goods industry. The above points for debtors turn over ratio hold good for this also. 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. For example debtors turn over ratio is 4. But there are capital goods industries with a very long production cycle and in such cases. Formula = Cost of goods sold/Average inventory held during the year. the average collection period would be 90 days. this would be less and consumer goods. The inventory should turn over at least 4 times in a year. 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. indicating improvement in liquidity.mbaskool. Then considering 360 days in a year. While receivables turn over contributes to liquidity. the ratio would be low. o Inventory turn over ratio – as said earlier. consumer goods – capital goods. but this depends upon so many factors such as. this would be higher and competitive it would be less as you are forced to give credit. this would be significantly higher.outstanding during the year. Formula for average collection period = 360/receivables turn over ratio. this contributes to profitability due to higher turn over. Any significant deviation from the past trend is of greater significance here than the absolute numbers. Hence the minimum would be 3 to 4 times. The less the production cycle. the average collection period would reduce. type of industry like capital goods. this directly contributes to the profitability of the organisation. o http://www. In case the debtors turn over ratio increases.com . Conditions of the market – monopolistic or competitive – monopolistic. No minimum and no maximum. 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.

Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The higher the level of stocks. However. The sales and profits are as under: Parameter Sales Unit A 1000lacs Unit B 1000lacs http://www. Units A and B are in the same type of business and operate at the same levels of capacities. we will study the following. this could indicate deterioration or improvement over a period of time. the lower would be the ratio and vice-versa. management’s policy towards working capital etc. Indicates operating efficiency. For example. Or maximum. 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. There is no min. Again this depends upon the type of industry.com . 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.the better the ratio and vice-versa.mbaskool. o Fixed assets turn over ratio Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. o Current assets turn over ratio – not much of significance as the entire current assets are involved. Cost of goods sold = Sales – profit – Interest charges. Formula = Cost of goods sold/Average value of fixed assets in the period (book value). 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. Formula = Cost of goods sold/Average current assets held in business during the year. market conditions.

o Profit margin on sales: Gross profit margin on sales and net profit margin ratio – Gross profit margin = Formula = Gross profit/net sales. administrative expenses and interest charges.com . Gross profit = Net sales (-) Cost of production before selling.Profits Profit margin on sales Return on capital employed 100lacs 10% 40% 90lacs 9% 45% While Unit A has higher profit margins.100lacs. Administrative expenses and interest Net profit 35lacs 5lacs 30lacs 5lacs Unit A 100lacs 60lacs 40lacs Unit B 100lacs 65lacs 35lacs 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. Parameter Sales Cost of production Gross profit Deduct: Selling general. Net sales = Gross sales (-) Excise duty. general. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs. For example in Unit A and Unit B let us assume that the sales are same at Rs. in case these are high. Unit B has better returns on capital employed. Unit B has more cost of production and less of office and selling expenses.mbaskool. http://www. 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.

In fact P/E http://www. Here the share refers to equity share and not preference share. This is the return on the shareholders’ funds including Preference Share capital. Tax rate being the same. Although reference is equity here. This is an important indicator about the return to equity shareholder.com . The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares.mbaskool. it is a cause for concern. Investment on capital ratios/Earnings ratios: o Return on net worth Profit After Tax (PAT) / Net worth. export activity etc.Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. o Return on capital employed (pre-tax) Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. o Earning per share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). available to one unit and not available to another unit. If it comes down over a period it means that the profitability of the organisation is suffering a setback. 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. In case there are tax concessions due to location in a backward area. Hence Preference Share capital is not deducted. If it reduces. There is no standard range for this ratio. Hence Preference dividend and Preference share capital are excluded. 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. There is no standard range for this ratio. then this comparison would not hold well. all equity shareholders’ funds are taken in the denominator. Again there is no standard range for this ratio. This gives return on long-term funds employed in business in pre-tax terms.

all liabilities are to be included in debt. Formula for debt/equity ratio = Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. The higher the PE the stronger is the recommendation to sell the share and the lower the PE. If on the other hand.e. we are concerned more with financial leverage. Equity in the beginning is the equity share capital.. Over a period of time it is net worth (-) redeemable preference share capital. From the working capital lending banks’ point of view. 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.com . the stronger is the recommendation to buy the share. Leverage ratios Leverages are of two kinds. it is the time for buying the shares. the P/E ratio of the unit is more than industry average P/E.ratio is related to this. as P/E ratio is the relationship between “Market value” of the share and the EPS. This is only indicative and by and large followed. unless we know for certain that the price is going to come down further. However. the market accepts a maximum of 2:1 at present. There is something known as industry average EPS. operating leverage and financial leverage. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula. Hence all external liabilities including current liabilities are taken into account for this ratio. it is time for us to sell unless we expect further increase in the near future. i. Given the advantage of debt also.mbaskool. It can be less. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. http://www. nonpayment of interest and non-repayment of principal amount increases with increase in debt capital component. as even risk of default. Financial leverage is the advantage of debt over equity in a capital structure.

o Asset coverage ratio This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. in the formula it gets added back to profit after tax. tax has to be paid and afterwards dividend and dividend tax. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. In case dividend is paid out. http://www. payment of interest and repayment of principal amount. Less than that indicates inadequate coverage of the liabilities. Minimum acceptable is 2 to 2. The assumption here is that dividend is ignored. especially medium and long-term. the formula gets amended to deduct from PAT dividend paid and dividend tax.Coverage ratios o Interest coverage ratio This indicates the number of times interest is covered by EBIT.5:1. Less than that is not desirable. as after paying interest. o Debt Service coverage ratio This indicates the ability of the business enterprise to service its borrowing. As interest is paid out of income and booked as an expense.5:1.com .mbaskool. Formula is: (Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off (+) Interest on medium and long-term borrowing (Denominator) Interest on medium and long-term borrowing (+) Installment on medium and long-term borrowing. Formula = EBIT / Interest payment on all loans including short-term liabilities. Accepted ratio is minimum 1. Servicing consists of two aspects namely.

both of which are not desirable. Current ratio = Current assets/current its short-term liabilities (also called liabilities. retained earnings would appear. Financial position of the company Relevant indicator/Remarks Net worth.e. Liquidity of the company. The minimum acceptable average for the entire period is 1.5:1. In the case of an existing company dividend will have to be paid and hence in the numerator. share capital.75:1. reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account. it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing.com .75:1. The above ratio is calculated for the entire period of the loan with the bank/financial institution. Quick ratio = Current assets (-) “current liabilities”) with the help of its inventory/ current liabilities. 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.This is assuming that dividend is not paid.mbaskool. 2. Current ratio current assets should not be too high like 4:1 or 5:1 or too low like less than 1. For a healthy company. Quick ratio could be at least 1:1. Quick ratio is a http://www.e. What is the objective behind analysis of financial statements? Objective (To know about) 1. whether Current ratio and quick ratio or acid test the company is in a position to meet all ratio. This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all. i. instead of PAT. i...

unsecured loans for this purpose. be it from investment in shares/debentures manufacturing. of the company. i.e. there is always accruals to finance the same? the risk of diverting working capital funds for fixed assets. 4.better indicator of liquidity position. income including other income.e.. i.. besides internal adequate financial planning. http://www. Whether the company has acquired new Examination of increase in secured or fixed assets during the year and if so. income operations etc.e. Operating profit. Without what are the sources. like dividend whether the main operations of the or interest income. 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.mbaskool. trading or services. This is best assessed through a funds flow statement for the period as even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets. Profitability of the company in general Percentage of profit before tax to total and operating profits in particular..com . 3.

6.mbaskool.5. Formula = External liabilities + (both short-term and long-term). From the lender’s point of view. Banks. What preference share capital /net worth of the about only medium and long-term company debts? (-) preference share capital (redeemable kind). please be on guard. this should not exceed 3:1. as the financial risk for the company increases to that extent. which establishes this the company and its external liabilities relationship. http://www.com . which immediately would reduce the net worth of the company. Relationship between the net worth of Debt/Equity ratio. it cannot exceed 2:1. Actual loss is booked upon only selling. which is reduced in value in comparison with last theoretically year? a loss in value of the investment. For only medium and long-term debts. Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less. The periodic reduction every year should warn us that at the time of actual sales. there would be substantial loss. Has the company’s investments in Difference between the market value of the shares/debentures of other companies investments and the purchase price. Is there any sharp deterioration in this ratio? Is so. Financial Institutions.

This should be greater than 1:1. it shows that while receivable management is quite good. expansion issue/Rights issue etc. which could cause problems in future. 9. like whether diversification programme.mbaskool.com . debtors in the year/average (bills receivable) and average creditors creditors in the year. the company is not paying its creditors. programme etc. Relationship between average debtors Average (bills payable) during the year. thereby creating Accounts” relevant for this. Too high a ratio would indicate that receivable management is very poor.7. as this is just an entry passed in the books? Frequent revaluation reserves. 8. Future plans of the company. http://www. which would be much less than the final sales value. If it is less than 1:1. creditors are at purchase price for software or components. entering financial plans for the company. Has the company revalued its fixed Auditors’ comments in the “Notes to assets during the year. into new collaboration agreement. of capital into the company. without any inflow revaluation is not desirable and healthy. as bills receivable are at gross value {cost of development (+) profit margin}. like Directors’ report. they are coming This would reveal the out with a public acquisition of new technology. whereas.

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. thereby increasing its cost of borrowing in future.undue increase in investment should put us period and cannot be liquidated in the on guard. http://www. or periodic interest on its liabilities? Any serious default is likely to affect the “credit rating” of the company with its lenders.mbaskool. what is the source shares/debentures/Govt. Has the company during the year given Any increase in unsecured loans. where the figures have increased. Are the company’s unsecured loans Any comments to this effect in the notes to (given) not recoverable and very old? accounts should put us on caution.com .10. 13. as working capital funds could near future? have been diverted for it. in for it? What is the nature of investment? comparison Is it in tradable securities or long-term with last year and any investment within group companies? Any Securities. Hence. Whether the company has increased its Increase in amount of investment in investment and if so. which can have a lock-in. further probing is called for. then all the more than to employees of the company? reason to be cautious. If the loans any unsecured loans substantially other are to group companies. 11. 12. This examination would indicate about likely impact on the future profits of the company. securities etc.

S. this should be higher even. this would be less. 16. capital? If it was a public issue. P. liability. gratuity liability etc? 15. 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. In a manufacturing company. net sales can be taken as the numerator). E. which is not in capital goods sector. Accounts” should be looked into. Whether the company is holding very Cash balance together with bank balance in huge cash.F. liability. Has the company defaulted in providing Any comments about this in the “Notes to for bonus liability. For a capital goods industry. 17. as it is not desirable and current account. this should not be less than 4:1 and for a consumer goods industry.I.com . How many times the average inventory Relationship between cost of goods sold and has turned over during the year? average inventory during the year (only where cost of goods sold cannot be determined.mbaskool. how did it fare in the market? http://www. is very high in the increases the opportunity cost? current assets. if any.14.

did it fare in the market? 20. increase in prices of finished products only? 22. thereby forcing the company to provide for the loss. 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. as it reduces liquidity on one hand and increases the risk of non-payment on due date. Any decrease should put us on guard. especially if the investment is in its own subsidiary or group companies. What is the increase in sales income over Comparison with previous year’s 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.mbaskool. Enquiry into the company’s ability to keep up the dividend rate of the immediate past. comparison with the previous year? 21. how at a premium. how much is it of total and doubtful debts or advances debts outstanding and what are the reasons http://www. in case the issue has been the issue? If it was a public issue. What is the amount of provision for bad In percentage terms. 19.com . What is the proportion of marketable Percentage of marketable investment to investment to total investment and total investment and comparison with whether this has decreased in previous year.18. Has the company issued any bonus Increase in paid-up capital and simultaneous shares during the year? reduction in general reserves.

Has the company changed its method of Auditors’ depreciation on fixed assets. Whether the company is paying any Examination of expenses schedule would lease rentals and if so what is the show this. 24. This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits. due to policies. 25.com .outstanding? for such provision in the notes to accounts by the auditors? 23. otherwise. ascertain correct external liability and to include the lease rentals in future also in projected income statements. What is the comment in notes to amount of lease liability outstanding? accounts about this? Lease liability is an offbalance sheet to item and hence the this examination. the company may be having much less disclosed liability and much more lease liability which is not disclosed. of the company? comments on “Accounting” Change over from straight-line which. there is an impact on the profits method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the http://www. What is the amount of work in progress Is there any comment about valuation of as shown in the Profit and Loss Account? work in progress by the auditors? It can be seen that profit from operations can be manipulated by increase/decrease in closing stocks of both finished goods and work in progress.mbaskool.

Minimum should be 3:1 and anything less than this is http://www. 26.com . Whether the % of administration and Relationship the year under review? between general and general expenses has increased during administrative expenses during the year and the sales. there is an impact of the profits of the company? comments on “Accounting” 28. increasing in relation to sales? 27. Relationship between materials consumed whether the % of materials consumed is during the year and the sales. In case there is any extraordinary increase. If it is a manufacturing company. what are the reasons therefore? 29. not satisfactory.profits during the year of change. Whether the company had sufficient Interest coverage ratio = earnings before income to pay the interest charges? interest and tax/total interest on all shortterm and long-term liabilities.mbaskool. due to which policies. Has the company changed its method of Auditors’ valuation of inventory.

31. Whether the % of employee costs to Relationship between “payment to and sales has increased? provision for employees” and the sales. 32. 33. 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? Is there any explanation for this. undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc.mbaskool. In case any undue increase is seen. any level in excess of 6% calls for examination.com . it could be due to expansion of activity etc. Whether the % of selling expenses in Relationship relation to sales has gone up? between “selling and Any marketing” expenses and the sales.30. like substantial expansion or new project or diversification for which the company has taken financial assistance? While a benchmark % is not available. that would be included in the Directors’ Report. Whether the company had sufficient Debt service coverage ratio = Internal internal accruals {Profit after tax (-) accruals (+) interest on medium and long- http://www.

interest cost on loans/debentures etc. This should be higher than the average cost of funds in the form of loans. Return on equity (includes reserves and Profit after tax (-) dividend on preference surplus) share capital/net worth (-) preference share capital (return in percentage). preliminary expenses and long-term liabilities (+) repayment of write-off etc.75:1 on an average for the loan period.. http://www. i.e. In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments. i. net worth (+) debt investment elsewhere.com .dividend (+) any non-cash expenditure term external liabilities/interest on medium like depreciation. 35. for 1.? 34. This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both by way of interest as well as repayment of the principal. capital. 36.e.mbaskool. Anything less than 15% means that our investment in this company is earning less than the average return in the market. The term-lending institution or bank looks debentures etc. Return on investment in business to Earnings before interest and tax/average compare it with return on similar total invested capital.} to meet repayment medium and long-term external liabilities.. obligation of principal amount of loans. How much earning has our share made? Profit after tax (-) dividend on preference (EPS) share capital/number of equity shares.

customs disputed amount of duties should put us on duty. sales tax. so. like purchase of fixed assets in the immediate future? 38.com . guard. letter of credit outstanding for which goods not yet received etc. 39. Has the company changed its policy of Substantial change in vendor charges. charges paid to consultants? http://www. or outsourcing its work from vendors and if subcontracting charges. octroi. Is there any reason for this like liquidity crunch that the company is experiencing or the need for conserving cash for business activity. what are the reasons? 40. 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. contracts remaining unexecuted. income tax. 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. guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company. Is there any substantial increase in Increase in consultancy charges.mbaskool.37. following? Any substantial increase especially in Disputed central excise duty.

(Link it with fundamental analysis.  Average key ratios in the industry in the country. there are several such pairs of parameters and hence ratio analysis assumes great significance. This information has to be obtained separately. inadequacy etc. In the statements of accounts.com . the scales of operation etc.41.  Balance sheet is as on a particular date and hence it does not indicate about the average for the entire year. ♦ Comparison with past trend within the same company is one type of analysis and comparison with the industrial average is another analysis Some of the limitations of the financial statements are given below :  Analysis and understanding of financial statements is only one of the tools in understanding of the company  The annual statements do have great limitations in their value. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units. of which the company is an integral part.) http://www. its strength. The principal tools of analysis are: ♦ Ratio analysis – i.mbaskool. Has the company opened any branch Directors’ Report or sudden spurt in general office in the last year? and administration expenses.e.  Key personnel behind the activity and human resources in the organisation. Hence it cannot indicate the position with 100% reliability. to determine the relationship between any set of two parameters and compare it with the past trend. come into play. as they do not speak about the following Management.

level of closing stocks and sales income to manipulate profits of the organisation.  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. to furnish details of tax paid in the annual statement of accounts. company personnel etc. as it is not mandatory under the provisions of The Companies’ Act. 1956.  To an extent at least. depending upon the requirement of the management during a particular year. http://www. The auditors’ report is based more on information given by the management.mbaskool. there can be manipulation in the level of expenditure.com .

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