Ratio Analysis

Ratio analysis—the foundation of fundamental analysis—helps to gain a deeper insight

into the financial health and the current and probable performance of the company being
studied. For this insight, the analysts use the quantitative method where the information
recorded in the company’s financial statements are compared and analyzed. And there are
certain formulae that are used for the same.

we shall discuss various Ratio Analysis, the various Ratios Formulae, and their importance.
We would look into the classification of ratios, where we have explained the importance of
using various ratios and the formulae to know how they are calculated. To help you learn
better and for the easy revisions later, you are provided here with the formulae for the
ratios that we have discussed in this series. Let’s move on and look into Ratio Analysis –
Ratios Formulae.

Liquidity Ratios
Also known as Solvency Ratios, and as the name indicates, it focuses on a company’s
current assets and liabilities to assess if it can pay the short-term debts. The three common
liquidity ratios used are current ratio, quick ratio, and burn rate. Among the three, current
ratio comes in handy to analyze the liquidity and solvency of the start-ups.

S. No. RATIOS FORMULAS

1 Current Ratio Current Assets/Current Liabilities

2 Quick Ratio Liquid Assets/Current Liabilities

3 Absolute Liquid Ratio Absolute Liquid Assets/Current Liabilities

Profitability Ratios
These ratios analyze another key aspect of a company and that is how it uses its assets and
how effectively it generates the profit from the assets and equities. This also then gives the
analyst information on the effectiveness of the use of the company’s operations.

S. RATIOS FORMULAS
No.

1 Gross Profit Ratio Gross Profit/Net Sales X 100

2 Operating Cost Ratio Operating Cost/Net Sales X 100

3 Operating Profit ratio Operating Profit/Net Sales X 100

4 Net Profit Ratio Operating Profit/Net Sales X 100

5 Return on Investment Ratio Net Profit After Interest  And Taxes/ Shareholders Funds or
Investments  X 100

6 Return on Capital Employed Net Profit after Taxes/ Gross Capital Employed X 100
Ratio

7 Earnings Per Share Ratio Net Profit After Tax & Preference Dividend /No of Equity Shares
 8 Dividend Pay Out Ratio Dividend Per Equity Share/Earning Per Equity Share X 100

9 Earning Per Equity Share Net Profit after Tax & Preference Dividend / No. of Equity Share

10 Dividend Yield Ratio Dividend Per Share/ Market Value Per Share X 100

11 Price Earnings Ratio Market Price Per Share Equity Share/ Earning Per Share X 100

Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts or
liabilities using the current assets. This ratio is crucial for the creditors to establish the
liquidity of a company, and how quickly a company converts its assets to bring in cash for
resolving the debts.

S. RATIOS FORMULAS
No.

1 Inventory Ratio Net Sales / Inventory

2 Debtors Turnover Ratio Total Sales /  Account Receivables

3 Debt Collection Ratio Receivables  x Months or days in a year / Net Credit Sales for
the year
 4 Creditors Turnover Ratio Net Credit Purchases / Average Accounts Payable

5 Average Payment Period Average Trade Creditors / Net Credit Purchases X 100

6 Working Capital Turnover Net Sales / Working Capital

Ratio

7 Fixed Assets Turnover Ratio Cost of goods Sold / Total Fixed Assets

8 Capital Turnover Ratio Cost of Sales / Capital Employed

Capital Structure Ratios

Each firm or company has capital or funds to finance its operations. These ratios, i.e., the
Capital Structure Ratios, analyze how structurally a firm uses the capital or funds.

S. No. RATIOS FORMULAS

1 Debt Equity Ratio Total Long Term Debts / Shareholders Fund

2 Proprietary Ratio Shareholders Fund/ Total Assets

 3 Capital Gearing ratio Equity Share Capital / Fixed Interest Bearing Funds

2nd

Financial Ratios

Financial ratios are a valuable and easy way to interpret the numbers found in statements. Ratio analysis provides
the ability to understand the relationship between figures on spreadsheets. It can help you to answer critical
questions such as whether the business is carrying excess debt or inventory, whether customers are paying
according to terms, and whether the operating expenses are too high.

When computing financial relationships, a good indication of the company's financial strengths and weaknesses
becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being
operated.

Many industries compile average (or standard) industry ratios each year. Standard or average industry ratios offer
the small business owner a means of comparing his or her company with others within the same industry. In this
manner they provide yet another measurement of an individual company’s strengths or weaknesses. RMA (Risk
Management Association, formerly named Robert Morris & Associates) is a good source of comparative financial
ratios. It can be found on the Internet at http://www.rmahq.org/

Following are the most critical ratios for most businesses, though there are others that may be computed.

1. Liquidity
Measures a company’s capacity to pay its debts as they come due. There are two ratios for evaluation
liquidity.

Current Ratio - Gauges how able a business is to pay current liabilities by using current assets only. Also
called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1, or 2/1).
However, an industry average may be a better standard than this rule of thumb. The actual quality and
management of assets must also be considered.
 The formula is:

Total Current Assets

Total Current Liabilities

Quick Ratio - Focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but specifically ignores
inventory. Also called the acid test ratio, it indicates the extent to which you could pay current liabilities
without relying on the sale of inventory. Quick assets, are highly liquid--those immediately convertible to
cash. A rule of thumb states that, generally, your ratio should be 1 to 1 (or 1:1, or 1/1).

The formula is:

Cash + Accounts Receivable

(+ any other quick assets)

Current Liabilities

2. Safety
Indicates a company’s vulnerability to risk--that is, the degree of protection provided for the business’ debt.
Three ratios help you evaluate safety:

Debt to Worth - Also called debt to net worth. Quantifies the relationship between the capital invested by
owners and investors and the funds provided by creditors. The higher the ratio, the greater the risk to a
current or future creditor. A lower ratio means your company is more financially stable and is probably in a
better position to borrow now and in the future. However, an extremely low ratio may indicate that you are
too conservative and are not letting the business realize its potential.

The formula is:

Total Liabilities (or Debt)

Net Worth (or Total Equity)

 Times Interest Earned – Assesses the company’s ability to meet interest payments. It also evaluates the
capacity to take on more debt. The higher the ratio, the greater the company’s ability to make its interest
payments or perhaps take on more debt.

The formula is:

Earnings Before Interest & Taxes

Interest Charges

Cash Flow to Current Maturity of Long-Term Debt - Indicates how well traditional cash flow (net profit plus
depreciation) covers the company’s debt principal payments due in the next 12 months. It also indicates if
the company’s cash flow can support additional debt.

The formula is:

Net Profit + Non-Cash Expenses*

Current Portion of Long-Term Debt

*Such as depreciation, amortization, and depletion.

3. Profitability
Measures the company’s ability to generate a return on its resources. Use the following four ratios to help
you answer the question, “Is my company as profitable as it should be?” An increase in the ratios is viewed
as a positive trend.

Gross Profit Margin - Indicates how well the company can generate a return at the gross profit level. It
addresses three areas: inventory control, pricing, and production efficiency.

The formula is:

 Gross Profit

Total Sales

Net Profit Margin - Shows how much net profit is derived from every dollar of total sales. It indicates how
well the business has managed its operating expenses. It also can indicate whether the business is
generating enough sales volume to cover minimum fixed costs and still leave an acceptable profit.

The formula is:

Net Profit

Total Sales

Return on Assets - Evaluates how effectively the company employs its assets to generate a return. It
measures efficiency.

The formula is:

Net Profit

Total Assets

Return on Net Worth - Also called return on investment (ROI). Determines the rate of return on the invested
capital. It is used to compare investment in the company against other investment opportunities, such as
stocks, real estate, savings, etc. There should be a direct relationship between ROI and risk (i.e., the
greater the risk, the higher the return).

The formula is:

Net Profit

Net Worth
4. Efficiency
Evaluates how well the company manages its assets. Besides determining the value of the company’s
assets, you should also analyze how effectively the company employs its assets. You can use the following
ratios:

Accounts Receivable Turnover - Shows the number of times accounts receivable are paid and reestablished
during the accounting period. The higher the turnover, the faster the business is collecting its receivables
and the more cash the company generally has on hand.

The formula is:

Total Net Sales

Average Accounts Receivable

Accounts Receivable Collection Period - Reveals how many days it takes to collect all accounts receivable.
As with accounts receivable turnover (above), fewer days means the company is collecting more quickly on
its accounts.

The formula is:

365 Days

Accounts Receivable Turnover

Accounts Payable Turnover - Shows how many times in one accounting period the company turns over
(repays) its accounts payable to creditors. A higher number indicates either that the business has decided
to hold on to its money longer, or that it is having greater difficulty paying creditors.

The formula is:

Cost of Goods Sold

Average Accounts Payable

Payable Period - Shows how many days it takes to pay accounts payable. This ratio is similar to accounts
payable turnover (above.) The business may be losing valuable creditor discounts by not paying promptly.
The formula is:

365 Days

Accounts Payable Turnover

Inventory Turnover - Shows how many times in one accounting period the company turns over (sells) its
inventory. This ratio is valuable for spotting understocking, overstocking, obsolescence, and the need for
merchandising improvement. Faster turnovers are generally viewed as a positive trend; they increase cash
flow and reduce warehousing and other related costs. Average inventory can be calculated by averaging
the inventory figure from the monthly Balance Sheets. In a cyclical business, this is especially important
since there can be wide swings in asset levels during the year. For example, many retailers might have
extra stock in October and November in preparation for the Thanksgiving and winter holiday sales.

The formula is:

Cost of Goods Sold

Average Inventory

Inventory Turnover in Days - Identifies the average length of time in days it takes the inventory to turn over.
As with inventory turnover (above), fewer days mean that inventory is being sold more quickly.

The formula is:

365 Days

Inventory Turnover

Sales to Net Worth - Indicates how many sales dollars are generated with each dollar of investment (net
worth). This is a volume ratio.

The formula is:

Total Sales
 Average Net Worth

Sales to Total Assets - Indicates how efficiently the company generates sales on each dollar of assets. A
volume indicator, this ratio measures the ability of the company’s assets to generate sales.

The formula is:

Total Sales

Average Total Assets

Debt Coverage Ratio - An indication of the company’s ability to satisfy its debt obligations, and its capacity
to take on additional debt without impairing its survival.

The formula is:

Net Profit + Any Non-Cash Expenses

Principal on Debt