Financial Ratios Analysis

Dr Saumya Jain

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What is a Ratio ?
Ratio is a relationship between two or
more items of the financial
statements. E.g. Net Profit Ratio
Profit A 65 B 45
Sales A 650 B 300

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 Ratio Analysis - Advantages
Ratios help stakeholders (like owners,
managers, investors, lenders, employees)
to draw conclusion about the
 Performance (past, present and future)
 Strengths & weakness
 And take decisions in relation to the firm

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Ratio Analysis
A single accounting figure by itself may not
communicate any meaningful information
but when expressed as a relative to some
other figure, it may definitely provide some
significant information.
Changing numbers in financial statement
make analysis by casual inspection
difficult
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 Ratio Analysis

Ratio analysis is not just comparing

different numbers from financial
statements. It involves comparing the
ratio against previous years, against
peers, and with the industry average
for the purpose of financial analysis.
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 Financial Ratio Analysis
 Financial Ratio Analysis is used to evaluate
the financial performance and condition of an
enterprise.
 Its provides decision making information for

external and internal users

 Financial ratio analysis helps measure the

firm’s progress towards financial goals.

 Primary goal of a business is to earn

satisfactory return on investment while

maintaining a sound financial position
Financial goals: Overview

Profitability
Satisfactory
Return on
Investment
Investment
Utilization
Primary financial
goals
Liquidity
Sound Financial
Position
Solvency/Stability
Types of Ratios

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Return on Investment
 Profitability
– Return obtained from
sales/Return from capital invested
 Investment Utilization- Effective use of assets

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Profitability Ratios
1) Gross Profit Margin/Ratio

(Revenue from operations)

 (1) Gross Profit = Net Sales - Cost of Goods Sold

 (2) Net Sales are Sales less Indirect Taxes
 (3) COGS =Opening Finished Goods+ Cost of goods manufactured - Closing finished
goods

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 1) Gross Profit Margin/Ratio

 Gross Profit ratio is a profitability ratio that shows the margin

generated by the firm through its trading or manufacturing
activities.
 This ratio measures the percentage of each sales rupee left to
cover other Operating & Non-Operating expenses.
 This ratio is also a reflection of the efficiency of a business in
using its inputs in the production process.

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2) Net Profit Margin/Ratio

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 Net Profit Margin/Ratio
 Net profit margin is a profitability ratio that indicates the
proportion of total income that is left after meeting all expenses
of the business (Operating, Financing & Investing).
 A high net profit margin indicates that the company is
generating more surplus for shareholders per rupee of total
inflows and is efficient in managing its expenses.
 Net Profit margin is an indicator of overall efficiency /financial
performance of the business
3) Return on Assets
 Return on Assets
 ROA = Net Income/ Average Total Assets

)

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3) Return on Assets
 Return on Assets measures the profitability of a business in
relation to its total assets. It compares the return generated by
the firm from its overall resources. It measures how efficiently
the company uses its assets to generate profit.
 Return on Assets is the most popular measure of a company’s
performance used by management, investors, analysts and
researchers.
 Can be compared with industry averages
 A higher ROA means the business is profitable and efficient. A
low ROA implies low profitability or over-capitalisation

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4) Return on Equity
ROE is a profitability measure which captures the return a company generates for
equity shareholders in relation to their funds. Higher ROE means that the company is
generating more profits per rupee of Equity shareholders’ funds. It is calculated as:

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 Ratios
2) Activity Ratios:
Activity ratios are also called as Turnover
ratios or Performance ratios. These ratios
are used to evaluate efficiency with which
the company manages and utilizes its
assets.

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Ratios
These ratios are usually calculated
with reference to sale/cost of goods
sold and are expressed in terms of
rate or times. Some of the important
activity ratios are as follows:

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 Ratios
a) Receivables Turnover Ratio

Average Accounts Receivables

Receivables : Debtors + Bills Receivables

Average accounts receivables : (Opening + Closing)/2

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 Receivables Turnover ratio is an activity ratio that measures the
efficiency with which the firm collects on the credit it issues to
customers/average number of days sales remain uncollected.
 A high turnover ratio indicates that either the firm has a tight
credit policy or the customers of the firm pay off their debts
quickly. A low Turnover ratio either indicates that the
company’s credit policy and collection procedures are lax or
the debtors of the firms take too much time in paying off.
Either way it casts light on the receivables management
policies of the firm

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Collection Period
 Average Collection Period = 360
Days / Receivables Turnover Ratio

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 Ratios
b) Inventory Turnover Ratio

 Generally, information on Cost of goods sold is not available in the annual

report, so alternatively, sales can be taken in place of COGS.
Inventory Turnover ratio is an activity ratio that measures the
efficiency with which the company converts its inventory into sales.
A high ratio implies fast sales and low ratio implies excess funds
tied up in inventory.

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 Ratios
c) Payables Turnover Ratio

Note: In the absence of information about Credit Purchases, we take total Purchases of
Stock in Trade (from Income Statement)

Payables : Creditors + Bills Payables

Average Payables: (Opening + Closing)/2

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Payables Turnover Ratio
 Payables Turnover ratio indicates the speed with which the
company is able to pay off its suppliers. This ratio can help
suppliers analyse the liquidity position of the company when
considering extending credit to the company.
 A high value indicates that the company pays off its vendors
quickly and a low ratio indicates from the point of view of
vendors, that the company is slow in paying off its creditors.
However, a low ratio is favourable from the point of view of
management as it might indicate that the company is able to
negotiate extended lines of credit from suppliers and also
enjoying interest free credit.

M Acc Varadraj Bapat, IIT Mumbai 25

 Ratios
d) Asset Turnover Ratio

Average Assets = (Opening Assets + Closing Assets)/2

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 Asset Turnover Ratio
 Asset Turnover ratio indicates the efficiency with which a company utilizes
its total assets in generating revenue.
 A high Asset Turnover in the same industry generally indicates the company
its utilizing its resources efficiently and generating more sales per rupee
invested in assets as compared to its peers.
 A low Asset Turnover generally implies poor inventory management, funds
blocked in unproductive assets, poor collection policy which all points to
inefficient use of resources.
 However, this ratio must also be analysed in terms of life of the company as
the company may be building up its assets before they start to generate
revenue.

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Fixed Assets Turnover Ratio

AS IND-AS
Fixed Assets: Shown as a line item under Non- Fixed Assets: No line item of Fixed Assets.
Current Assets
Non-Current Assets consist of:
Consists of:
a) PPE
a) Tangible Assets
b) Capital Work in Progress
b) Intangible assets
c) Investment Property
c) Capital Work in Progress
d) Goodwill
d) Intangible Assets under Development
e) Other intangible assets
f) Intangible Assets under development
g) Biological assets other than bearer plants

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Fixed Assets Turnover ratio

 Fixed Assets Turnover Ratio is used to measure the Operating efficiency of

a firm. It compares the revenue generated per rupee of Fixed/Non-Current
Operating Assets held for use in the business.
 A high ratio indicates that the firm is able to generate sales with a lower
investment in fixed assets. A low ratio would indicate excess production
capacity or build-up of fixed assets in anticipation of launch of new product

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 Liquidity Ratios
Liquidity Ratios: Liquidity ratios measure the short-term solvency of the
company i.e. ability of the company to meet its current obligations.
a) Current Ratio

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 Liquidity Ratios
Current Ratio

 The main question this ratio address is: Does business

have enough current assets to meet its current debts.
 A generally acceptable current ratio is 2:1.But whether or
not a specific ratio is satisfactory depends on the nature of
business and composition of current assets.

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 Liquidity Ratios
 Quick ratio is a liquidity ratio that measures a
company’s ability to meet it current liabilities with
its most liquid assets (quick assets).
 Quick ratio is a more rigorous measure of

immediate liquidity

Quick Assets = Cash & Cash Equivalents+ Net Trade Receivables+

Marketable Current investments

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 Ratios
• The quick ratio is a much more
conservative measure than current
ratio.
• This ratio measure the immediate
solvency of the company.
• The ideal liquid ratio is 1:1. This is
irrespective of nature of business.
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Solvency Ratios
 Solvency Ratios measure the ability of the firm to meet its debt-related
obligations as and when they fall due.

 These ratios are important indicators of financial health of the company and
are carefully analysed by lenders and shareholders who are interested in
long term survival of the company

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1) Debt-Equity ratio
 This ratio represents the relative proportion of internal funds (shareholders’
funds) versus external funds (long-term debt) used to finance a company’s
assets. This is also popularly known as financial leverage.

 A high debt equity ratio indicates that the company is being financed more
by lenders than owners.

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2) Interest Coverage Ratio
 Interest Coverage ratio measures the adequacy of company’s operating
profits to meet its interest payments. It is a safety margin for lenders,
indicating how many times over its interest obligation a company is earning.

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 3) Total Debt to Total Assets
 This ratio measures the proportion of a company’s assets that
are financed by debt. If a company has high debt ratio, it is an
indication that the company must commit a significant portion
of its cash flows to principal and interest payments.

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Market Value Ratios
 Market Value ratios help the investors of publicly traded companies to
analyse the company’s performance against observable market prices.
 Basic Earnings Per Share
 Earnings per share depict the proportion of company’s profit attributable to
each share of equity.

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Book Value per Share

 Book value per share (BVPS) is the value of equity share as per the financial
statements of a company.

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1) Price Earnings Ratio (P/E)
 The P/E ratio helps investors analyse whether the share is overvalued or
undervalued by comparing the market value of a stock with
the company's earnings. The P/E ratio shows the market expectations about
the company’s performance in the form of market price.
 A high P/E could mean that a stock's price is high relative to earnings and
possibly overvalued or the investors expect the company to grow at a faster
rate. Conversely, a low P/E indicates that the current stock price is low
relative to earnings i.e. the stock is undervalued

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2) Market to Book Ratio or Price to Book Ratio
 Market-Book ratio is an important metric used by investors to evaluate
whether a company is under-valued or over-valued by comparing its book
value to its market capitalization.
 Book value seeks to represent how much the net assets are worth in the
event of liquidation as per the books.
 The market capitalization represents the amount the market is willing to pay
for the stock of the company.
 Traditionally, a ratio below 1 indicates that the stock is undervalued or if it
is more than one, it indicates that the stock is overvalued

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Other Ratios
 Dividend Payout Ratio :
 The Dividend Payout Ratio (DPR) is the amount of dividends paid to
shareholders in relation to the total amount of net income the
company generates.
 The dividend payout ratio measures the percentage of net income that is
distributed to shareholders in the form of dividends

D/P ratio : Dividends/Net Income (PAT)

Or
D/P ratio : DPS/ EPS

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Other Ratios
 The retention ratio is the proportion of earnings kept back in
the business as retained earnings. The retention ratio refers to
the percentage of net income that is retained to grow the
business, rather than being paid out as dividends.
 Retention Ratio = (Net Income – Dividends)/Net Income
or
Retention Ratio = (EPS–DPS)/EPS

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Q1) You are given the Balance sheet and extract of
Statement of Profit & Loss of two companies belonging to
the same industry. Comment on the following :

Assets Company A Company B

(1) Non-Current Assets:
PPE 25,00,000 34,00,000
Investment Property 5,00,000 1,00,000
Goodwill 3500000 1,40,000
Biological Assets 1230000 4,50,000
Financial Assets:
Investments 500000 300000
Loans 800000 500000
Other Non-Current Assets 300,000 220,000
9330000 5110000

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Ques)
Assets Company A Company B
(2) Current Assets:

Inventories 0 0
Financial Assets:
Investments 2,50,000 30,000
Trade Receivables 5,00,000 3,40,000
Cash & Cash Equivalents 15,60,000 6,50,000
Loans 3,40,000 1,50,000
2650000 1170000
Total Assets 11980000 6280000

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Ques)
Equity and Liabilities Company A Company B
Equity
Equity Share Capital 2345000 1105000
Other Equity 3280000 1050000
Liabilities
Non- current Liabilities
Financial Liabilities
Borrowings 4581000 1500000
Other Financial Liabilities 45000 15000
Current Liabilities
Financial Liabilities
Borrowings 1229000 2270000
Trade payables 500000 340000
Total Equity and Liabilities 46
11980000 6280000
The following information is extracted from SPL:

Particulars Company A Company B

Revenue from
Operations 6000000 2500000
Cost of goods sold 1400000 1200000
Other Operating
expenses 350000 55000
Finance Costs (Interest) 1300000 150000
Taxes 737500 273750
Dividends 1500000 500000

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Answer each of the following questions by making a comparison of one or more
relevant ratios
(i) Which company is using the equity shareholders’ money more profitably?
(ii) Which company has better liquidity?
(iii) Which company collects its receivables faster, assuming all the sales to be credit
sales?
(iv) Which company retains the larger proportion of income in the business?
(v) Which company is enjoying higher profit margins?
(vi) Which company pays out higher proportion of dividend?
(vii) As a lender which company would you consider lending to?

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Ans

ROE 0.524444 0.508121

liquidity

CR 1.532678 0.448276

QR 1.336032 0.390805

RTR 12 7.352941

RET RATIO 0.491525 0.543379

Net Profit margin 0.491667 0.438

Gross Profit margin 0.766667 0.52

Debt Equity 0.8144 0.696056

Interest Coverage 3.269231 8.3

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