This detailed elaboration focuses specifically on financial ratios, providing formulas,

interpretations, and practical examples to enhance your understanding for the UGC NET
Commerce exam.

UGC NET Commerce: Financial Ratios -

Detailed Elaboration with Examples
Financial ratios are powerful tools that simplify complex financial data into meaningful,
comparable metrics. They help analysts, investors, and managers assess various aspects of a
company's financial health and operational efficiency. To truly understand them, it's crucial to
grasp not just the formula, but also what each ratio tells you and how to interpret it in context.

I. Liquidity Ratios
Liquidity ratios measure a company's ability to meet its short-term financial obligations (those
due within one year). A company with good liquidity can easily convert its assets into cash to
cover its immediate liabilities.

1. Current Ratio
●​ Formula: \frac{\text{Current Assets}}{\text{Current Liabilities}}
●​ Interpretation: This is the most common liquidity ratio. It indicates the extent to which
current assets (cash, accounts receivable, inventory, etc.) can cover current liabilities
(accounts payable, short-term loans, etc.).
○​ Ideal Ratio: Generally, a current ratio of 2:1 or higher is considered healthy,
meaning the company has twice as many current assets as current liabilities.
○​ High Ratio: A very high ratio (e.g., 4:1) might indicate inefficient use of assets,
such as too much cash lying idle or excessive inventory.
○​ Low Ratio: A ratio below 1:1 suggests that the company may struggle to meet its
short-term obligations, potentially leading to liquidity problems.
●​ Example:
○​ Company A: Current Assets = ₹5,00,000; Current Liabilities = ₹2,50,000
○​ Calculation: Current Ratio = ₹5,00,000 / ₹2,50,000 = 2:1
○​ Interpretation: Company A has ₹2 of current assets for every ₹1 of current
liabilities, indicating a healthy short-term financial position.

2. Quick Ratio (Acid-Test Ratio)

●​ Formula: \frac{\text{Current Assets - Inventory}}{\text{Current Liabilities}} OR
\frac{\text{Cash + Marketable Securities + Accounts Receivable}}{\text{Current Liabilities}}
●​ Interpretation: This is a more conservative measure than the current ratio because it
excludes inventory from current assets. Inventory might not be easily or quickly
convertible into cash, especially if it's slow-moving or obsolete.
○​ Ideal Ratio: An ideal quick ratio is typically 1:1 or higher, meaning the company
has enough highly liquid assets to cover its short-term debts.
 ○​ Industry Variation: This ratio is particularly useful for businesses with large
inventories (e.g., manufacturing, retail) where inventory liquidation can be
uncertain.
●​ Example:
○​ Company A (from above): Current Assets = ₹5,00,000; Current Liabilities =
₹2,50,000; Inventory = ₹1,00,000
○​ Calculation: Quick Ratio = (₹5,00,000 - ₹1,00,000) / ₹2,50,000 = ₹4,00,000 /
₹2,50,000 = 1.6:1
○​ Interpretation: Company A has ₹1.6 of highly liquid assets for every ₹1 of current
liabilities, which is a strong position.

3. Cash Ratio
●​ Formula: \frac{\text{Cash + Marketable Securities}}{\text{Current Liabilities}}
●​ Interpretation: This is the most stringent liquidity ratio, focusing only on the most liquid
assets (cash and easily marketable securities). It shows the company's ability to pay off
current liabilities immediately without relying on converting receivables or inventory.
○​ Usefulness: Useful for evaluating highly conservative companies or in times of
economic uncertainty.
●​ Example:
○​ Company A: Cash = ₹1,50,000; Marketable Securities = ₹50,000; Current
Liabilities = ₹2,50,000
○​ Calculation: Cash Ratio = (₹1,50,000 + ₹50,000) / ₹2,50,000 = ₹2,00,000 /
₹2,50,000 = 0.8:1
○​ Interpretation: Company A can cover 80% of its current liabilities with just cash
and marketable securities. While not 1:1, this might be acceptable depending on
industry norms and expected cash inflows.

II. Solvency Ratios (Leverage Ratios)

Solvency ratios measure a company's ability to meet its long-term financial obligations. They
indicate the extent to which a company relies on borrowed funds versus owner's funds.

1. Debt-Equity Ratio
●​ Formula: \frac{\text{Total Debt}}{\text{Shareholders' Equity}} (often, only long-term debt is
considered as 'Debt')
●​ Interpretation: This ratio compares the total debt (both long-term and short-term, or
sometimes just long-term debt) used to finance assets with the equity (owner's funds).
○​ High Ratio: A high ratio (e.g., above 2:1 or depending on industry) indicates a
greater reliance on debt, which increases financial risk (higher interest burden, risk
of default) but can also magnify returns for shareholders if the borrowed funds are
invested profitably (financial leverage).
○​ Low Ratio: A low ratio implies less reliance on debt, indicating financial
conservatism and lower risk.
●​ Example:
○​ Company B: Total Debt = ₹8,00,000; Shareholders' Equity = ₹4,00,000
 ○​ Calculation: Debt-Equity Ratio = ₹8,00,000 / ₹4,00,000 = 2:1
○​ Interpretation: Company B has ₹2 of debt for every ₹1 of equity. This is a relatively
high ratio, suggesting the company is significantly leveraged. This could be risky if
its earnings decline, making it difficult to service debt.

2. Total Debt to Total Assets Ratio

●​ Formula: \frac{\text{Total Debt}}{\text{Total Assets}}
●​ Interpretation: This ratio indicates the percentage of a company's assets that are
financed by debt.
○​ High Ratio: A high ratio means a large portion of assets are debt-financed,
implying higher risk.
○​ Low Ratio: A low ratio means assets are primarily financed by equity, indicating a
more stable financial structure.
●​ Example:
○​ Company B: Total Debt = ₹8,00,000; Total Assets = ₹12,00,000
○​ Calculation: Total Debt to Total Assets Ratio = ₹8,00,000 / ₹12,00,000 = 0.67 or
67%
○​ Interpretation: 67% of Company B's assets are financed by debt. This reinforces
the observation from the debt-equity ratio that the company has a high level of
financial leverage.

3. Proprietary Ratio
●​ Formula: \frac{\text{Shareholders' Equity}}{\text{Total Assets}}
●​ Interpretation: This ratio shows the proportion of total assets that are financed by the
owners' funds (equity). It's the inverse of the Total Debt to Total Assets ratio (if there's no
preference share capital or reserves not part of equity).
○​ High Ratio: A higher ratio means greater financial strength and stability, as the
company relies less on external borrowings.
○​ Low Ratio: A low ratio indicates a greater dependence on debt, which can be risky.
●​ Example:
○​ Company B: Shareholders' Equity = ₹4,00,000; Total Assets = ₹12,00,000
○​ Calculation: Proprietary Ratio = ₹4,00,000 / ₹12,00,000 = 0.33 or 33%
○​ Interpretation: 33% of Company B's assets are financed by equity. This confirms
that a significant portion (67%) is debt-financed.

4. Interest Coverage Ratio (Times Interest Earned Ratio)

●​ Formula: \frac{\text{EBIT (Earnings Before Interest & Tax)}}{\text{Interest Expense}}
●​ Interpretation: This ratio measures a company's ability to cover its interest expenses with
its operating earnings.
○​ Higher Ratio: A higher ratio indicates a greater ability to meet interest obligations,
implying lower risk for lenders. A ratio below 1.5 or 2 suggests potential difficulty in
meeting interest payments.
○​ EBIT (Operating Profit): This is chosen because interest is paid out of operating
profits before taxes.
●​ Example:
 ○​ Company C: EBIT = ₹5,00,000; Interest Expense = ₹1,00,000
○​ Calculation: Interest Coverage Ratio = ₹5,00,000 / ₹1,00,000 = 5 times
○​ Interpretation: Company C's operating earnings are 5 times its interest expense,
indicating a comfortable ability to service its debt.

III. Activity Ratios (Efficiency / Turnover Ratios)

Activity ratios measure how efficiently a company is utilizing its assets to generate sales or
revenue. They indicate the speed at which assets are converted into sales or cash.

1. Inventory Turnover Ratio

●​ Formula: \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Inventory}}
○​ Where Average Inventory = (Opening Inventory + Closing Inventory) / 2
●​ Interpretation: This ratio indicates how many times a company sells and replaces its
inventory during a period.
○​ Higher Ratio: Generally, a higher ratio is better, implying efficient inventory
management, strong sales, and less risk of obsolescence.
○​ Lower Ratio: A low ratio might suggest slow-moving or obsolete inventory,
overstocking, or weak sales.
○​ Industry Specific: This ratio varies significantly by industry (e.g., a grocery store
will have a much higher turnover than a car dealership).
●​ Example:
○​ Company D: COGS = ₹8,00,000; Opening Inventory = ₹1,50,000; Closing
Inventory = ₹2,50,000
○​ Calculation:
■​ Average Inventory = (₹1,50,000 + ₹2,50,000) / 2 = ₹2,00,000
■​ Inventory Turnover Ratio = ₹8,00,000 / ₹2,00,000 = 4 times
○​ Interpretation: Company D sells and replaces its entire inventory 4 times a year.
This means inventory is held for an average of 365/4 = 91.25 days.

2. Debtors Turnover Ratio (Receivables Turnover Ratio)

●​ Formula: \frac{\text{Net Credit Sales}}{\text{Average Trade Receivables (Debtors + Bills
Receivable)}}
○​ Where Average Trade Receivables = (Opening Receivables + Closing Receivables)
/2
●​ Interpretation: This ratio measures how quickly a company collects its accounts
receivables.
○​ Higher Ratio: A higher ratio indicates efficient credit management and faster
collection of dues, reducing the risk of bad debts.
○​ Lower Ratio: A low ratio might indicate lax credit policies, inefficient collection
efforts, or financially distressed customers.
○​ Also calculate Average Collection Period (Days Sales Outstanding): \frac{365
\text{ Days}}{\text{Debtors Turnover Ratio}}
●​ Example:
○​ Company E: Net Credit Sales = ₹10,00,000; Opening Debtors = ₹1,00,000;
 Closing Debtors = ₹1,50,000
○​ Calculation:
■​ Average Trade Receivables = (₹1,00,000 + ₹1,50,000) / 2 = ₹1,25,000
■​ Debtors Turnover Ratio = ₹10,00,000 / ₹1,25,000 = 8 times
■​ Average Collection Period = 365 / 8 = 45.63 days
○​ Interpretation: Company E collects its receivables 8 times a year, or on average
every 45.63 days. This provides insight into its credit and collection policies.

3. Creditors Turnover Ratio (Payables Turnover Ratio)

●​ Formula: \frac{\text{Net Credit Purchases}}{\text{Average Trade Payables (Creditors +
Bills Payable)}}
○​ Where Average Trade Payables = (Opening Payables + Closing Payables) / 2
●​ Interpretation: This ratio measures how quickly a company pays its suppliers.
○​ Higher Ratio: A higher ratio means the company is paying its suppliers quickly.
○​ Lower Ratio: A lower ratio means the company is taking longer to pay its suppliers.
This could indicate good cash management (taking advantage of credit periods) or
a sign of liquidity issues.
○​ Also calculate Average Payment Period: \frac{365 \text{ Days}}{\text{Creditors
Turnover Ratio}}
●​ Example:
○​ Company F: Net Credit Purchases = ₹6,00,000; Opening Creditors = ₹80,000;
Closing Creditors = ₹1,20,000
○​ Calculation:
■​ Average Trade Payables = (₹80,000 + ₹1,20,000) / 2 = ₹1,00,000
■​ Creditors Turnover Ratio = ₹6,00,000 / ₹1,00,000 = 6 times
■​ Average Payment Period = 365 / 6 = 60.83 days
○​ Interpretation: Company F pays its creditors 6 times a year, or on average every
60.83 days.

4. Working Capital Turnover Ratio

●​ Formula: \frac{\text{Net Sales}}{\text{Working Capital (Current Assets - Current
Liabilities)}}
●​ Interpretation: This ratio indicates how effectively a company is using its working capital
to generate sales.
○​ Higher Ratio: A higher ratio suggests efficient utilization of working capital.
○​ Lower Ratio: A low ratio might indicate over-investment in current assets or
inefficient management of current liabilities.
●​ Example:
○​ Company G: Net Sales = ₹15,00,000; Current Assets = ₹4,00,000; Current
Liabilities = ₹2,00,000
○​ Calculation:
■​ Working Capital = ₹4,00,000 - ₹2,00,000 = ₹2,00,000
■​ Working Capital Turnover Ratio = ₹15,00,000 / ₹2,00,000 = 7.5 times
○​ Interpretation: Company G generates ₹7.5 of sales for every ₹1 of working capital.
5. Fixed Assets Turnover Ratio
●​ Formula: \frac{\text{Net Sales}}{\text{Net Fixed Assets}}
●​ Interpretation: Measures how effectively a company is using its fixed assets (e.g., plant,
machinery, buildings) to generate sales.
○​ Higher Ratio: Generally indicates better utilization of fixed assets.
○​ Lower Ratio: Could imply underutilization of assets, old or inefficient assets, or
over-investment in fixed assets.
●​ Example:
○​ Company H: Net Sales = ₹20,00,000; Net Fixed Assets = ₹10,00,000
○​ Calculation: Fixed Assets Turnover Ratio = ₹20,00,000 / ₹10,00,000 = 2 times
○​ Interpretation: Company H generates ₹2 of sales for every ₹1 invested in fixed
assets.

6. Total Assets Turnover Ratio

●​ Formula: \frac{\text{Net Sales}}{\text{Total Assets}}
●​ Interpretation: This ratio measures the overall efficiency with which a company uses all
its assets (current and non-current) to generate sales.
○​ Higher Ratio: Indicates that the company is effectively utilizing its asset base to
generate revenue.
●​ Example:
○​ Company H: Net Sales = ₹20,00,000; Total Assets = ₹15,00,000
○​ Calculation: Total Assets Turnover Ratio = ₹20,00,000 / ₹15,00,000 = 1.33 times
○​ Interpretation: Company H generates ₹1.33 of sales for every ₹1 of total assets.

IV. Profitability Ratios

Profitability ratios measure a company's ability to generate profits from its sales, assets, and
equity. They are crucial for investors and management to assess performance.

1. Gross Profit Ratio

●​ Formula: \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100
●​ Interpretation: This ratio indicates the percentage of sales revenue remaining after
deducting the Cost of Goods Sold (COGS). It reflects the company's pricing strategy and
efficiency in production.
○​ Higher Ratio: Generally indicates a strong ability to control production costs or
good pricing power.
●​ Example:
○​ Company I: Net Sales = ₹10,00,000; COGS = ₹6,00,000
○​ Calculation:
■​ Gross Profit = ₹10,00,000 - ₹6,00,000 = ₹4,00,000
■​ Gross Profit Ratio = (₹4,00,000 / ₹10,00,000) * 100 = 40%
○​ Interpretation: Company I earns a gross profit of 40% on every rupee of sales.
2. Net Profit Ratio
●​ Formula: \frac{\text{Net Profit After Tax}}{\text{Net Sales}} \times 100
●​ Interpretation: This ratio shows the percentage of sales revenue that remains as net
profit after all operating expenses, interest, and taxes have been deducted. It indicates
overall efficiency and cost control.
○​ Higher Ratio: Generally desirable, as it means more profit per rupee of sales.
●​ Example:
○​ Company I: Net Sales = ₹10,00,000; Net Profit After Tax = ₹1,50,000
○​ Calculation: Net Profit Ratio = (₹1,50,000 / ₹10,00,000) * 100 = 15%
○​ Interpretation: Company I earns a net profit of 15% on every rupee of sales.

3. Operating Profit Ratio

●​ Formula: \frac{\text{Operating Profit (EBIT)}}{\text{Net Sales}} \times 100
○​ Where Operating Profit = Gross Profit - Operating Expenses (Admin, Selling,
Distribution Expenses)
○​ Or Operating Profit = Net Sales - COGS - Operating Expenses
●​ Interpretation: This ratio focuses on the profitability of the core business operations
before considering interest and taxes. It reflects operational efficiency in managing core
business costs.
○​ Higher Ratio: Indicates better management of operating expenses.
●​ Example:
○​ Company I: Net Sales = ₹10,00,000; Operating Expenses = ₹2,00,000; COGS =
₹6,00,000
○​ Calculation:
■​ Operating Profit = ₹10,00,000 - ₹6,00,000 - ₹2,00,000 = ₹2,00,000
■​ Operating Profit Ratio = (₹2,00,000 / ₹10,00,000) * 100 = 20%
○​ Interpretation: 20% of Company I's sales revenue translates into operating profit.

4. Return on Capital Employed (ROCE)

●​ Formula: \frac{\text{EBIT (Earnings Before Interest & Tax)}}{\text{Capital Employed
(Shareholders' Equity + Long-Term Debt)}} \times 100
○​ Alternatively, Capital Employed = Total Assets - Current Liabilities
●​ Interpretation: This ratio measures the overall profitability of the capital invested in the
business, irrespective of how it is financed (debt or equity). It shows how efficiently a
company uses its total capital to generate profits.
○​ Higher Ratio: Indicates better utilization of capital.
●​ Example:
○​ Company J: EBIT = ₹7,00,000; Shareholders' Equity = ₹20,00,000; Long-Term
Debt = ₹10,00,000
○​ Calculation:
■​ Capital Employed = ₹20,00,000 + ₹10,00,000 = ₹30,00,000
■​ ROCE = (₹7,00,000 / ₹30,00,000) * 100 = 23.33%
○​ Interpretation: Company J generates a 23.33% return on the total capital
employed in its business.
5. Return on Shareholders' Funds (ROSF) / Return on Equity (ROE)
●​ Formula: \frac{\text{Net Profit After Tax - Preference Dividend}}{\text{Shareholders'
Equity}} \times 100
●​ Interpretation: This ratio measures the return generated for equity shareholders on their
investment. It is a very important ratio for investors.
○​ Higher Ratio: Generally indicates effective use of shareholders' money to generate
profits.
○​ Dupont Analysis: ROE can be decomposed into Profit Margin, Asset Turnover,
and Financial Leverage to understand its drivers.
●​ Example:
○​ Company K: Net Profit After Tax = ₹3,00,000; Preference Dividend = ₹50,000;
Shareholders' Equity = ₹15,00,000
○​ Calculation: ROSF = (₹3,00,000 - ₹50,000) / ₹15,00,000 * 100 = ₹2,50,000 /
₹15,00,000 * 100 = 16.67%
○​ Interpretation: For every ₹100 invested by equity shareholders, Company K
generated ₹16.67 in profit after tax and preference dividends.

6. Earnings Per Share (EPS)

●​ Formula: \frac{\text{Net Profit After Tax - Preference Dividend}}{\text{Number of Equity
Shares Outstanding}}
●​ Interpretation: This ratio indicates the portion of a company's profit allocated to each
outstanding ordinary share. It is a key profitability metric used by investors.
○​ Higher EPS: Generally indicates better profitability per share.
●​ Example:
○​ Company K: Net Profit After Tax = ₹3,00,000; Preference Dividend = ₹50,000;
Number of Equity Shares = 1,00,000
○​ Calculation: EPS = (₹3,00,000 - ₹50,000) / 1,00,000 = ₹2,50,000 / 1,00,000 =
₹2.50
○​ Interpretation: Each equity share of Company K earned ₹2.50 during the period.

7. Dividend Per Share (DPS)

●​ Formula: \frac{\text{Total Dividend Paid to Equity Shareholders}}{\text{Number of Equity
Shares Outstanding}}
●​ Interpretation: The actual amount of dividend received by each equity share.
●​ Example:
○​ Company K: Total Dividend Paid to Equity Shareholders = ₹1,25,000; Number of
Equity Shares = 1,00,000
○​ Calculation: DPS = ₹1,25,000 / 1,00,000 = ₹1.25
○​ Interpretation: Each equity share of Company K received a dividend of ₹1.25.

8. Price-Earnings (P/E) Ratio

●​ Formula: \frac{\text{Market Price Per Share}}{\text{Earnings Per Share (EPS)}}
●​ Interpretation: This is a market valuation ratio that indicates how much investors are
 willing to pay for every rupee of a company's earnings.
○​ Higher P/E: Often suggests that investors expect higher future earnings growth, or
the stock is considered "growth stock."
○​ Lower P/E: Might indicate a "value stock" (potentially undervalued), or concerns
about future growth, or higher risk.
○​ Comparison: P/E ratios are best compared within the same industry or with the
market average.
●​ Example:
○​ Company L: Market Price Per Share = ₹250; EPS = ₹10
○​ Calculation: P/E Ratio = ₹250 / ₹10 = 25 times
○​ Interpretation: Investors are willing to pay 25 times Company L's annual earnings
for each share. This suggests strong market confidence or high growth
expectations.

9. Dividend Yield Ratio

●​ Formula: \frac{\text{Dividend Per Share (DPS)}}{\text{Market Price Per Share}} \times
100
●​ Interpretation: This ratio measures the return on investment in terms of dividends
received, expressed as a percentage of the current market price of the share.
○​ Usefulness: Relevant for income-focused investors.
●​ Example:
○​ Company L: DPS = ₹5; Market Price Per Share = ₹250
○​ Calculation: Dividend Yield Ratio = (₹5 / ₹250) * 100 = 2%
○​ Interpretation: Company L's shares currently yield a 2% return in the form of
dividends.

V. Key Considerations for Ratio Analysis:

●​ Industry Standards: Ratios are most meaningful when compared against industry
averages or direct competitors. What's good in one industry might be poor in another
(e.g., high debt in banking vs. low debt in tech).
●​ Trend Analysis: Analyzing a company's ratios over several periods (e.g., 3-5 years)
provides insight into its performance trajectory and consistency.
●​ Qualitative Factors: Ratios are quantitative. Always complement ratio analysis with
qualitative factors like management quality, economic outlook, competitive environment,
and regulatory changes.
●​ Limitations: Be aware of the limitations of financial analysis, such as window dressing,
historical data, and the impact of different accounting policies.
●​ Source Data: Ensure the data used for calculation is from reliable, audited financial
statements.
By understanding these ratios in detail with examples, you'll be well-equipped to tackle related
questions in the UGC NET Commerce exam.