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Financial Ratios - An Important Analysis Tool


CA AJIT YADKIKAR 
posted on 25 January 2013



Financial analysis of any organization is collection, study, evaluation, interpretation, and presentation of financial data to assist various types of decision making. This analysis is useful to various categories of users like management, shareholders, creditors, potential investors, tax authorities, auditors etc.

 

Financial Ratios provide a solid base for understanding and interpreting financial health of a company or any business entity.

 

What is Financial Ratio?

 

A ratio represents mathematical relation or comparison between two single amounts or quantities. For example Gross Profit ratio is percentage of turnover equal to gross profit earned during a specific period.

 

Ratio analysis is used for judging financial health of an organization in terms of its profitability, liquidity, solvency and capital adequacy.

 

Types of Ratios

 

Following are the common types of financial analysis ratios categorized according to information they provide.

 

LIQUIDITY RATIOS

 

These ratios measure a company’s ability to meet its short term debts and obligations

 

RATIO

FORMULA

PURPOSE

Current Ratio

Current Assets/Current Liabilities

 

Judges ability of a company to meet short term liabilities

Acid Test (Quick) Ratio

Cash + Marketable investments + Current Receivables / Current Liabilities

 

Shows liquidity position without relying on inventories or non liquid assets

Cash Ratio

Cash+Cash equivalents +Invested Funds / Current Liabilities

Further refines quick ratio by considering only cash and its equivalents

Operating Cycle

DIO+DSO-DPO

Here

DIO=Days inventory outstanding

 DSO= Days sales outstanding

 DPO= Days payable  outstanding

 

Indicates the length of time (in days) that a company uses to sell inventories, collect debtors and pay off its creditors. Shorter the cycle, stronger the liquidity position

 

PROFITABILITY RATIOS

 

These ratios measure profitability and financial performance. We can get insight into how well an entity is using its resources to generate profit.

 

RATIO

FORMULA

PURPOSE

Gross Profit Ratio

Gross Income / Sales

Shows gross margin as percentage of sales

Operating Profit Margin

Operating Profit / Sales

(Operating profit=EBIT)

Indicates operating performance in terms of profit

 

Net Profit Ratio

 

Net Profit / Sales

Assesses  bottom-line profitability

 

Return on Assets

Net Profit / Total Assets

Reveals how well management is employing assets of the company to make profit

Return on Capital Employed

Net Income / Capital Employed

(Capital includes share capital +Long tern Debts)

Measures company’s ability to generate returns on available capital base. Important ratio for analyst and management

 

LEVERAGE /CAPITAL STRUCTURE RATIOS

 

These ratios provide information on capital structure and financial leverage used by a company.

 

RATIO

FORMULA

PURPOSE

Debt-Equity Ratio

Total Debt / Shareholders Fund

Compares shareholders fund to total long term debts of a company. A lower ratio indicates strong equity position, higher the ratio it shows the company using more leverage

Capitalization Ratio

Long Term Debt / Long Term Debt + Shareholders Equity     

Measures debt component in company’s capital structure. It gives clear information about a company’s use of leverage

 

COVERAGE RATIOS

 

A company’s ability to meet its fixed debt obligations id judged by this type of ratios.

 

RATIO

FORMULA

PURPOSE

Interest Coverage Ratio

 Earnings Before Interest & Taxes/ Interest payable on loans

Ascertains a company’s ability to pay off interest outstanding on total debt.

 

Debt Service Coverage Ratio

(DSCR)

 

 

 

EBIT + Depreciation / Installments Payable

Gives insight on company’s position to service its debt payments i.e. principal installments +interest

 

OPERATING PERFORMANCE RATIOS

 

These ratios measure overall operating performance of a company. It aims to ascertain how well resources are used by management to increase stakeholders worth.

 

RATIO

FORMULA

PURPOSE

 Fixed Assets Turnover Ratio

Sales / Fixed Assets

Shows a company’s efficiency to productively manage fixed assets. In other words it measures productivity of fixed assets in terms of generating revenues or turnover

Inventory Turnover Ratio

Cost of Goods sold  / Average Inventory

Measures how many times inventory has been created and sold during a period.

 

Accounts Receivables Turnover

Credit Sales / Average Accounts Receivables

Ascertains how many times accounts receivables have been turned into cash during a specific period

 

CAPITAL MARKET RATIOS

 

These ratios used by investors and analysts to estimate potential and value of shares of a company. They have direct impact on decision of investment.

 

RATIO

FORMULA

PURPOSE

Earning per Share

Net Profit available to shareholders / No. of shares outstanding

Indicates amount of income earned per share during a period. It has impact on share market price

Price Earning Ratio (P/E Ratio)

Market Price per share / Earning per share

Indicator of whether a share is relatively cheap or costly in share market.

 

RATIOS CONSIDERED AS IMPORTANT BY BANKS / FINANCIAL INSTITUTIONS (IN CASES OF MEDIUM, SMALL BUSINESSES)

 

Current Ratio: Should be more than 1. A ratio of 2:1 is considered sound.

 

Quick Ratio: Should be around 1

 

Debt Equity Ratio: Up to 2:1. Should not be higher than 2 in any case

 

Debt Service Coverage Ratio: Minimum coverage of 125%. Here earnings before interest, taxes and depreciation are considered while ascertaining coverage.

 

Inventory Turnover ratio: It should be consistent with the nature of business.

 

Operating cycle: Should be in line with the business activity and market conditions


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