Financial Ratios

A ratio is an arithmetical relationship between two amounts. Financial Ratio analysis is a

study of ratios between various amounts and groups of items seen in the financial
statements. Ratio analysis is a very important and commonly used tool for analysis
because of its simplicity and effectiveness. When the value of any item is given in
absolute number terms, it may not give the entire picture whereas when expressed as a
ratio the entire meaning is apparent.

Financial Ratios can be mainly divided into the following categories:

.. Liquidity ratios
.. Profitability ratios
.. Leverage ratios/Financial stability /Solvency ratios
.. Turnover ratios /Activity Ratios
.. Valuation ratios /Management efficiency

Let us solve all the ratios by means of an example.

2) The following are extracts from the balance sheet of ABC ltd for two financial years

Assets 2003-04 2002-03

Current assets
Cash in hand and bank 2,00,000 1,60,000
Debtors 3,20,000 4,00,000
Stock 18,40,000 21,60,000
Temporary Investments 2,00,000 3,20,000
Prepaid expenses 28,000 12,000

Total Current assets 25,88,000 30,52,000

Total assets 56,00,000 64,00,000

Liabilities
Equity share capital (Rs 100 20,00,000 20,00,000
each)
Retained Earnings 4,68,000 2,58,000
Debentures 16,00,000 16,00,000

Current liabilities 6,40,000 8,00,000

Long term loans 8,92,000 1,742,000

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 56,00,000 64,00,000

The following is the data for the year ending 2003-04

Net Sales = Rs 40,00,000

Cost of Goods sold = 28,00,000

Purchases =16,00,000 out of which 100000 were cash purchases

Admn and selling expenses = 2,00,000

Interest = Rs 1,80,000

Assume that all of the sales are on cash

basis

Dividend paid = Rs 2,00,000

MPS = Rs 85
Assume tax =50%

Liquidity Ratios
Liquidity ratios as the name implies are the ratios which measure the liquidity position of
a firm. This means that the company’s ability to meet its short term obligations is judged
through these ratios. Simply put, the liquidity ratios compare the current assets and
current liabilities and try to find out if the company’s liquid assets are enough to pay off
its current liabilities. Liquidity ratios consist of
a).. Current ratio
b) Liquid ratio or Acid test ratio or Quick ratio

Current Ratio: This is the relationship between the total current assets of a company and
its total current liabilities. It is measured as :

Current Assets/Current Liabilities

Current assets include all the short term assets such as cash and bank
balances, inventory, receivables, debtors, loans and advances and prepaid
expenses. Current liabilities include all short term liabilities such as
Creditors, Loans, Bank overdraft ,Bills payable etc .
A higher ratio means that the current assets are that much more than current
liabilities. This means that after meeting all current liabilities, the firm has
enough current assets.. Normally an ideal current ratio is said to be 2 indicating that the
value of current assets must be at least twice as much as the current liabilities. A ratio less
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than 1 indicates a very bad liquidity position as this means the company has very little
short termand liquid funds to meet its current obligations. Again there may be exceptions
to this

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rule. A company having very tight inventory position and also enjoying liberal credit
terms from its suppliers will have a very low current ratio. However this does not indicate
the financial weakness of the company but only sound fund management.A very high
CR could also mean improper utilization/investment of money.

The current ratio for company would be for 2003-04 would be 4.04 and 2002-03 would
be 3.815 .In this case the company ‘s CR has increased from one year to another.The
company was already having a very high current ratio and the increase is probably not
that good for the company. The increase has happened because the proportionate
decrease in current liabilities(17%) is more than the proportionate decrease in current
assets(15%).The decrease in CL is not good because it gives the company less float of
money and less time to pay off creditors .

Liquid Ratio (Quick ratio/Acid test ratio): Among all current assets, inventory is
considered to be the least liquid. This is because it takes considerable time and effort to
convert the unfinished and unsold goods into sales and realize cash from them. Therefore
it was felt that in order to judge the liquidity position of the firm more effectively, one
has to remove the inventory value from the current assets. This logic was the basis of the
emergence of the quick ratio. The ratio is calculated as follows:
Quick Assets/Current Liabilities
Here the term quick assets refer to the value of current assets less
Inventory less prepaid expenses . The current liabilities are the same as in the
current ratio.

The quick ratio of this company has increased to 1.125(720000/640000) from

1.1(880000/800000.The quick ratio is reasonable and well within limits. However, the
calculation of quick ratio shows that the company is holding a very huge proportion of its
current assets in the form of stock .This has reduced to some extent in 2003-04.This still
needs to be checked. Such a huge proportion in the form of stock could lead to wastage,
deterioration and losses. It could also mean that the stock is not fast moving. The
inventory turnover ratio would be a better indicator of that .

It is thus seen that the quick ratio indicates the liquidity position more
effectively. When the difference between the current ratio and quick ratio is
considerably high, it is a clear indicator that more than desirable amount is
locked up in the form of stock. A better inventory management policy becomes the
need of the hour in this case.

Profitability Ratios
Profitability ratios are a measure of the final results of a business
organization.

.. Gross Profit margin

.. EBITDA margin

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.. Net Profit margin

Gross Profit margin: The gross profit margin expresses gross profit as a percentage on
sales. It is measured as:

Gross Profit / Net sales

Gross profit= sales- cost of goods sold(raw materials used+factory expenses)

The above ratio can be converted in percentage terms by multiplying the ratio by 100.
The GP ratio of this company is 30%.This means that 70% of its expenses go towards
its core activity of production
The gross profit margin is a measure of production as well as product pricing as the
margin is arrived at by taking the manufacturing expenses into consideration. The higher
the margin, the better the pricing and production policy of the company.

EBIT(Operating) margin: This ratio measures the relationship between the

Earnings before interest and tax and the net sales. It is measured as:
Earnings before interest and tax/ Net sales

EDIT= Sales- COGS- admn and office expenses- selling expenses

Depn is assumed to be included in COGS/Admn expenses

The EBIT margin of our company is 25%.This ratio reflects the operational efficiencyof
the firm. The higher the ratio the better for the company. This shows that the company’s
office and selling expenses are very low in proportion to its manufacturing expenses.
This is normally a positive sign.However, it may even be possible that the company is
not concentrating enough on selling and distribution and advertisement and if more
money is spent on these the sales could go up.

Net Profit margin: Net Profit ratio measures the relationship between the net profit after
tax and the net sales. It is measured as:
PAT or EAT / Net Sales
PAT or EAT is calculated as follows:
EBITDA – Depn and amortization = EBIT
EBIT - interest = EBT
EBT- tax = EAT or PAT

The net profit margin our company is 10.25% .

This ratio shows how much of the profits are actually available to the shareholders of the
company after meeting all expenses including tax. In our example, though the gross profit
margin was 30% the net profit margin is about 10.25%, thus showing the effect of all
expenses after the manufacturing expenses have been accounted for. The higher the net
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profit margin the better it is. The gross profit and net profit margins must be considered
and analyzed together to know the company’s cost and price efficiency.

Return on Equity: This ratio, ROE, is very useful for equity shareholders as it gives the
rate of return on the amount invested by equity shareholders. It is measured as:
( Equity earnings/ Equity share holders funds )*100
The equity earning is nothing but the profit after tax(PAT) less the preference
dividend. This is the amount actually available for distribution as profits to
equity shareholders. The denominator includes amount contributed by
shareholders consisting of paid up capital and reserves and surplus. This
ratio is also called Return on net worth.
The ratio ( 410000 / 2468000) *100 = 16.61%
As the objective of any firm is to maximize the shareholder value, ROE
becomes an important indicator of the company’s accounting results. The
higher the ROE the more attractive it is for the shareholder.

Return on Capital Employed: This ratio is calculated as:

(EBIT/ Equity shareholders funds+pref shareholders funds+long term
loans+debentures )*100

The ratio is : (10,00,000 /56,00,000)*100 = 17.85%

The comparison between ROCE and ROE helps us find out the return which the
company has generated on equity shareholders funds vis-a-vis the return on all the
asets.It also helps us to get an idea about the preference dividend and interest burden of
the company.

Leverage ratios
Leverage ratios are used to assess the use of debt as a source of finance for business. The
cost of debt is usually lower than the other sources of finance. However, it is also a
source of higher risk for the firm. When a firm has more of debts than equity, it might fall
into a debt trap or a situation in which loan repayment or interest payment becomes
impossible. Also when a company already has heavy debts, any new project might not get
further debt from financial institutions as the credit worthiness and leverage position of
the firm is not favorable. The leverage ratios help in measuring the risk associated with
debt capital.

Debt Equity ratio: This ratio gives the proportion of debt and equity in a
company’s capital structure. It is measured as:
Total Debt/ Total Equity
Total debt = short term loans + long term debt+ debenturesTotal
Equity= Equity share capital + reserves and surplus+pref
shareholders funds

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Note:There are different methods of calculating DE ratios.Some do not include current liabilities.

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The DE ratio is here is within limits. This ratio indicates how much money of owners
funds is there wrt outside money. If outside money/borrowings of a company is too high,
it will have a high interest burden.There is also the possibility that the company may be
unable to pay off its loans leadingto risk of bankruptcy .Too low a ratio means that the
company is not utilizing having a good balance of debt and equity with respect to its
sources of finance .Loan funds have the lowest interest rate lower than preference share
capital ad equity capital) and are preferable over other sources of finance from this point
of view.A lower ratio,however, indicates a more desirable position for a company’s
creditors and lenders. This providesprotection to the lenders as more money is
contributed by owners than lenders.

Turnover ratios
Turnover ratios or activity ratios measure how efficiently assets are used by a firm. A
relationship is established between the level of activity denoted by sales or cost of goods
sold and the level of assets employed by the firm. The important turnover ratios are:
.. Inventory turnover
.. Receivables turnover
.. Creditors Turnover Ratio
..
Inventory turnover ratio: This ratio measures the speed at which inventory
of a firm is converted into sales. A higher ratio indicates the more efficient conversion of
inventory into sales and revenues. There could be exceptions to this rule. A higher
turnover ratio could also be caused by very low level of inventory which could result in
stock-outs, production stoppages etc impacting customer satisfaction and goodwill.

It is measured as:
Cost of goods sold/Closing inventory

This co has the inventory turnover ratio of: 28,00,000 /18,40,000 = 1.52
Hence stock moves only once in 236 days which is very slow. The company is spending
too much on holding and storage costs and should also try to improve its sales/help the
stock move faster .

Debtors’ Turnover ratio: This ratio measures how many times debtors turn over into
sales during an accounting year. It is better to take the credit sales alone as the numerator
as cash sales is anyway realized immediately. However when it is not possible to
determine the amount of credit sales, the net sales can be taken . The higher the ratio the
better is the credit management of the firm.
It is measured as:

Net credit sales / Closing debtors

The ratio is: 40,00,000/3,20,000 = 12.5

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Average collection period is 28.8 days. Hence the company collects money from its
debtors pretty quickly. Probably the company is having a very strict credit policy and this
could also be one of the reasons for slow moving stock(of finished goods) .The average
collection period from debtors can also be determined from the above ratio as:
360/ Debtors’ turnover ratio. This collection period is
compared with the credit period of the firm to measure the firm’s credit management
policy. Typically the collection period must be lower than the credit period enjoyed by
the firm.

Creditors Turnover Ratio = This shows how much time the company gets to pay its
creditors.If the company’s average credit period is higher than its collection period it is
good for the company. Annual credit purchases/closing creditors

1500000/640000 = 2.34 and annual credit period = 153 days. So the company is getting a
lot of time to pay its creditors. This will help the company in managing float of money to
the maximum.

Valuation ratios

Valuation ratios are more useful for equity investors as they measure the value of the
share in the market. These are also known as market ratios. These ratios are a
comprehensive measure of a firm’s value in the market. The various valuation ratios are:

Earnings per share = This shows the earnings of an equity share holder on one share
held by Him.The higher it is the better. Earnings per share is
nothing but Profit after tax less preference dividend divided by the number
of equity shares.

EPS = Rs 410000/20000 = 20.5 per share

Dividend per share. This ratio indicates the dividend paid to an equity share holder for
one share held by him
DPS= dividend per share/No of equity shares

200000/20000= 10 per share

A company that pays steady and regular

dividends is valued by

shareholders.However it must be noted that

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paying too much of dividends is a sign of

lack of reinvestment opportunities and

growth and may not be seen as a good sign

by shareholders.

Price earnings ratio: This is the most popular ratio in any stock market
report and analysis. It is measured as:

Market price per share/ Earnings per share

The market price is the price as on a particular day.

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PE ratio is: 85/20.5 = 4.14

This ratio indicates the price that the market is willing to pay for every rupee earned on a
share. The ratio is to be compared with the industrial average ratio before making any
decision on buying the share. If the company’s ratio is very high as compared to other
companies PE/Industrial average then it could mean that the share is over priced and it is
not the right time to buy the share. A lower than average ratio indicates an under priced
stock which can be bought now expecting a good appreciation. One must be cautious
while interpreting PE ratios, For eg,a high PE ratio might also be a sign of high
anticipated growth in a company ( High expected MPS/low current EPS).This means
that the particular company is likely to grow at a much higher rate than the industry.In
such a case it good to buy such a share . Similarly a low PE Ratio could also be an
indication of low growth,in which case one should not buy the share.Hence while PE
Ratio is a very important metric it should be used in combination with the other financial
ratios.If the financial position of a company is strong accompanied be a high PE ratio ,it
is likely to be a good buy.

Similary PE ratios can be calculated using current EPS,Trailing twelve months EPS or
projected EPS.It is important to understand how PE ratio has been calculated and
compare it with the industry before drawing any conclusion.

Anlaysis of ratios
Once the ratios are calculated they have to be compared with the industry average and the
competitors’ measures to judge the financial strength of the firm. Graphical
representations with the industry average and the company’s ratios help the management
in making policy decisions. Also instead of calculating ratios for just one year, the same
can be calculated for a series of years to judge the improvement in performance of the
company. This way an unusually good or poor ratio can be justified and
corrective measures can be taken. Graphical representations of the time series ratios also
help in quickly judging the movement of a company’s liquidity, profitability and leverage
positions. In general the financial ratios offer the following advantages for a
company:
a. Assessing the firm’s excellence
b. Judging the creditworthiness
c. Forecasting bankruptcy and taking preventive measures
d. Valuing shares
e. Estimating market risk
f. Predicting debenture ratings
Financial ratio analysis also has its own limitations too. These are as listed
below:
a. Lack of clear theory to suggest the methods of interpretation
b. Unsuitable for multi-industry firms
c. Encourages window dressing
d. Confusion in using many ratios
e. Price level changes not considered in Balance sheet values
f. Variations in accounting policies of different firms in an industry
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Irrespective of the few demerits, financial ratio analysis is the most
effective and commonly used analytical tool that helps the stakeholders to
get adequate information and make necessary decisions regarding
improving performance, buying or selling shares, lending loans etc.

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