# Financial Ratios - An Important Analysis Tool

CA AJIT YADKIKAR , 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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