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Ratio Analysis Quick Summary

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:

Types of the Ratios

Summary of Ratios

Liquidity Ratio

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.

Current Ratio

(b) Quick Ratio

It measures the ability to meet current debt immediately. Ideal ratio is 1 : 1.

Quick Ratio

Quick Assets = Current Assets − Inventories − Prepaid expenses

(c) Cash Ratio

It measures absolute liquidity of the business.

Cash Ratio

(d) Basic Defense Interval Ratio

It measures the ability of the business to meet regular cash expenditures.

Basic Defense Interval

(e) Net Working Capital Ratio

It is a measure of cash flow to determine the ability of business to survive financial crisis.

Net Working Capital Ratio

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.

Equity Ratio

(b) Debt Ratio

It is an indicator of use of outside funds.

Debt Ratio

(c) Debt to Equity Ratio

It indicates the composition of capital structure in terms of debt and equity.

Debt to Equity Ratio

(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.

Capital Gearing Ratio

(f) Proprietary Ratio

It measures the proportion of total assets financed by shareholders.

Proprietary Ratio

Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve & Surplus. Total assets exclude fictitious assets and losses.

Coverage Ratios

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.

Debt Service Coverage Ratio (DSCR)

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.

Interest Coverage Ratio

(c) Preference Dividend Coverage Ratio

It measures the ability to pay the preference shareholders’ dividend. Ideal ratio is > 1.

Preference Dividend Coverage Ratio

(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.

Fixed Charges Coverage Ratio

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.

Total Asset Turnover Ratio

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.

Fixed Assets Turnover Ratio

(c) Capital Turnover Ratio

This indicates the firm’s ability to generate sales per rupee of long term investment.

Capital Turnover Ratio

(d) Working Capital Turnover Ratio

It measures the efficiency of the firm to use working capital.

Working Capital Turnover Ratio

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.

Inventory Turnover Ratio

(ii) Debtors Turnover Ratio

It measures the efficiency at which firm is managing its receivables.

Debtors Turnover Ratio

(iii) Receivables (Debtors’) Velocity

It measures the velocity of collection of receivables.

Receivables (Debtors’) Velocity

(iv) Payables Turnover Ratio

It measures the velocity of payables payment.

Payables Turnover Ratio

Profitability Ratios

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:

  1. Profitability Ratios related to Sales
  2. Profitability Ratios related to overall Return on Investment
  3. Profitability Ratios required for Analysis from Owner’s Point of View
  4. 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.

Gross Profit Ratio

(b) Net Profit Ratio

It measures the relationship between net profit and sales of the business.

Net Profit Ratio

(c) Operating Profit Ratio

It measures operating performance of business.

Operating Profit Ratio

(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.

Cost of Goods Sold (COGS) Ratio

(ii) Operating Expenses Ratio

It measures portion of a Operating Expenses in comparison to sales.

Operating Expenses Ratio

(iii) Operating Ratio

It measures portion of a COGS & Operating Expenses in comparison to sales.

Operating Ratio

(iv) Financial Expenses Ratio

It measures portion of a Financial Expenses in comparison to sales.

Financial Expenses Ratio

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.

Return on Investment (ROI)

(b) Return on Assets (ROA)

It measures net profit per rupee of average total assets/ average tangible assets/ average fixed assets.

Return on Assets (ROA)

(c) Return on Capital Employed ROCE (Pre-tax)

It measures overall earnings (either pre-tax or post tax) on total capital employed.

Return on Capital Employed ROCE (Pre-tax)

(d) Return on Equity (ROE)

It measures the profitability of equity funds invested in the firm.

Return on Equity (ROE)

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.

Earnings Per Share (EPS)

(b) Dividend per Share (DPS)

It indicates the amount of profit distributed to equity shareholders per share.

Dividend Per Share (DPS)

(c) Dividend Pay-out Ratio (DP)

It measures the dividend paid in relation to net earnings.

Dividend pay-out Ratio (DP)

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.

Price Earnings per Share (P_E Ratio)

(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.

Dividend and Earning Yield

(c) Market Value /Book Value per Share (MVBV)

It measures the market response of the shareholders’ investment.

Market Value_ Book Value Per Share

(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.

Q Ratio

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