Ratio analysis is a comparison of different numbers from the balance sheet, income statement, and cash flow statement against the figures of previous years, other companies, the industry, or even the economy in general for the purpose of financial analysis.
Types of Ratios:
Summary of Ratios
Liquidity or short-term solvency means ability of the business to pay its short-term liabilities.
Various Liquidity Ratios are:
(a) Current Ratio
A simple measure that estimates whether the business can pay short term debts. Ideal ratio is 2 : 1.
(b) Quick Ratio
It measures the ability to meet current debt immediately. Ideal ratio is 1 : 1.
Quick Assets = Current Assets − Inventories − Prepaid expenses
(c) Cash Ratio
It measures absolute liquidity of the business.
(d) Basic Defense Interval Ratio
It measures the ability of the business to meet regular cash expenditures.
(e) Net Working Capital Ratio
It is a measure of cash flow to determine the ability of business to survive financial crisis.
Capital Structure Ratio
These ratios provide an insight into the financing techniques used by a business and focus, as a consequence, on the long-term solvency position.
Various capital structure ratios are:
(a) Equity Ratio
It indicates owner’s fund in companies to total fund invested.
(b) Debt Ratio
It is an indicator of use of outside funds.
(c) Debt to Equity Ratio
It indicates the composition of capital structure in terms of debt and equity.
(d) Debt to Total Assets Ratio
It measures how much of total assets is financed by the debt.
(e) Capital Gearing Ratio
It shows the proportion of fixed interest bearing capital to equity shareholders’ fund. It also signifies the advantage of financial leverage to the equity shareholder.
(f) Proprietary Ratio
It measures the proportion of total assets financed by shareholders.
Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve & Surplus. Total assets exclude fictitious assets and losses.
The coverage ratios measure the firm’s ability to service the fixed liabilities.
The following are important coverage ratios:
(a) Debt Service Coverage Ratio (DSCR)
It measures the ability to meet the commitment of various debt services like interest, installment etc. Ideal ratio is 2.
Earning available for debt service = Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other amortizations + Interest +other adjustments like loss on sale of Fixed Asset etc.
(b) Interest Coverage Ratio
It measures the ability of the business to meet interest. Ideal ratio is > 1.
(c) Preference Dividend Coverage Ratio
It measures the ability to pay the preference shareholders’ dividend. Ideal ratio is > 1.
(d) Fixed Charges Coverage Ratio
This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. The ideal ratio is > 1.
Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. For this reason, they are often called ‘Asset management ratios’.
Based on different concepts of assets employed, it can be expressed as follows:
(a) Total Asset Turnover Ratio
This ratio measures the efficiency with which the firm uses its total assets. Higher the ratio, better it is.
COGS = Cost of Goods Sold
(b) Fixed Assets Turnover Ratio
This ratio is about fixed asset capacity. A reducing sales or profit being generated from each rupee invested in fixed assets may indicate overcapacity or poorer-performing equipment.
(c) Capital Turnover Ratio
This indicates the firm’s ability to generate sales per rupee of long term investment.
(d) Working Capital Turnover Ratio
It measures the efficiency of the firm to use working capital.
Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors Turnover.
(i) Inventory Turnover Ratio
It measures the efficiency of the firm to manage its inventory.
(ii) Debtors Turnover Ratio
It measures the efficiency at which firm is managing its receivables.
(iii) Receivables (Debtors’) Velocity
It measures the velocity of collection of receivables.
(iv) Payables Turnover Ratio
It measures the velocity of payables payment.
The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business operations.
The profitability ratios are broadly classified in four categories:
- Profitability Ratios related to Sales
- Profitability Ratios related to overall Return on Investment
- Profitability Ratios required for Analysis from Owner’s Point of View
- Profitability Ratios related to Market/ Valuation/ Investors.
Profitability Ratios based on Sales
(a) Gross Profit Ratio
This ratio tells us something about the business’s ability consistently to control its production costs or to manage the margins it makes on products it buys and sells.
(b) Net Profit Ratio
It measures the relationship between net profit and sales of the business.
(c) Operating Profit Ratio
It measures operating performance of business.
(d) Expenses Ratio
Based on different concepts of expenses it can be expresses in different variants as below:
(i) Cost of Goods Sold (COGS) Ratio
It measures portion of a COGS in comparison to sales.
(ii) Operating Expenses Ratio
It measures portion of a Operating Expenses in comparison to sales.
(iii) Operating Ratio
It measures portion of a COGS & Operating Expenses in comparison to sales.
(iv) Financial Expenses Ratio
It measures portion of a Financial Expenses in comparison to sales.
Profitability Ratios related to Overall Return on Assets/ Investments
(a) Return on Investment (ROI)
It measures overall return of the business on investment/ equity funds/ capital employed/ assets.
(b) Return on Assets (ROA)
It measures net profit per rupee of average total assets/ average tangible assets/ average fixed assets.
(c) Return on Capital Employed ROCE (Pre-tax)
It measures overall earnings (either pre-tax or post tax) on total capital employed.
(d) Return on Equity (ROE)
It measures the profitability of equity funds invested in the firm.
Profitability Ratios Required for Analysis from Owner’s Point of View
(a) Earnings per Share (EPS)
It measures the profitability of a firm from the point of view of ordinary shareholders.
(b) Dividend per Share (DPS)
It indicates the amount of profit distributed to equity shareholders per share.
(c) Dividend Pay-out Ratio (DP)
It measures the dividend paid in relation to net earnings.
Profitability Ratios related to market/ valuation/ Investors
(a) Price-Earnings Ratio (P/E Ratio)
It measures the payback period to the investors or prospective investors.
(b) Dividend and Earning Yield
It measures the return on investment; this may be on average investment or closing investment. Dividend (%) indicates return on paid up value of shares but yield (%) is the indicator of true return in which share capital is taken at its market value.
(c) Market Value /Book Value per Share (MVBV)
It measures the market response of the shareholders’ investment.
(d) Q Ratio
It measures the relationship between market valuation and intrinsic value. Equilibrium is when Q Ratio = 1 because when it is less than 1, it could mean that the stock is undervalued and when it is more than 1, it could mean that stock is overvalued.