NCERT Textbook: Ratio Analysis | Financial Literacy for Class 10 PDF Download

 Page 1


RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
Introduction to Financial Markets
67
Page 2


RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
Introduction to Financial Markets
67
RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
66
Page 3


RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
Introduction to Financial Markets
67
RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
66
(iii) Interest Coverage Ratio =
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The 
lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt 
service capacity of a firm. Financial institutions calculate the average DSCR for the period 
during which the term loan for the project is repayable. The Debt Service Coverage Ratio is 
defined as follows:
Profit after tax + Depreciation + Other Non cash Expenditure + Interest on term loan
Interest on Term Loan + Repayment of term loan
Profitability and operating/management efficiency of a firm is judged mainly by the following 
profitability ratios:
(i) Gross Profit Ratio (%) =                       * 100
(ii) Net Profit Ratio (%) =                    * 100
Some of the profitability ratios related to investments are:   
(iii) Return on Total Assets =
(iv) Return on Capital Employed =
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -Current Liabilities)
(v) Return on Shareholders’ Equity = 
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., 
only after claims of creditors and preference shareholders are fully met, the equity shareholders 
receive a distribution of profits or assets on liquidation. A measure of his well being is reflected 
by return on equity. There are several other measures to calculate return on shareholders’ equity 
of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per 
share, that is, the amount that they can get on every share held. It is calculated by dividing 
the profits available to the shareholders by number of outstanding shares. The profits 
available to the ordinary shareholders are arrived at as net profits after taxes minus 
preference dividend.
It indicates the value of equity in the market.
EPS =
(ii) Price-Earnings Ratios = P/E Ratio =
(III) Profitability Ratios:
Net Profit Available to the Shareholder
Number of Ordinary Shares Outstanding
Net Profit after Tax
Average Total Shareholders Equity or Net Worth
Net Profit after Tax
Total Capital Employed
Profit Before Interest and Tax
Fixed Assets + Current Assets
Net Profit
Net Sales
Gross Profit
Net Sales
Earnings Before Interest and Taxes
Interest
Marketer ice per Share
EPS
Opening Stock 13.00 Sales (net) 105.00
Purchases 69.00 Closing Stock 15.00
Wages and Salaries 12.00
Other Mfg. Expenses 10.00
Gross Profit 16.00
Total 120.00 Total 120.00
Administrative and Personnel Expenses 1.50 Gross Profit 16.00
Selling and Distribution Expenses 2.00
Depreciation 2.50
Interest 1.00
Net Profit 9.00
Total 16.00 Total 16.00
Income Tax 4.00 Net Profit 9.00
Equity Dividend 3.00
Retained Earning 2.00
Total 9.00 Total 9.00
Market price per equity share = Rs. 20.00
Particulars Amount Particulars Amount
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.00 Cash & Bank 0.20
Unsecured Loans 25.00 Debtors 11.80
Current Liabilities & Provisions 16.00 Inventories 10.60
Pre-paid expenses 0.80
Investments 16.60
Total 100 Total 100
Liabilities Amount Assets Amount
Profit & Loss Account of ABC Co. Ltd. for the year ending on March 31, 2005:
Introduction to Financial Markets
69
Page 4


RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
Introduction to Financial Markets
67
RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
66
(iii) Interest Coverage Ratio =
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The 
lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt 
service capacity of a firm. Financial institutions calculate the average DSCR for the period 
during which the term loan for the project is repayable. The Debt Service Coverage Ratio is 
defined as follows:
Profit after tax + Depreciation + Other Non cash Expenditure + Interest on term loan
Interest on Term Loan + Repayment of term loan
Profitability and operating/management efficiency of a firm is judged mainly by the following 
profitability ratios:
(i) Gross Profit Ratio (%) =                       * 100
(ii) Net Profit Ratio (%) =                    * 100
Some of the profitability ratios related to investments are:   
(iii) Return on Total Assets =
(iv) Return on Capital Employed =
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -Current Liabilities)
(v) Return on Shareholders’ Equity = 
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., 
only after claims of creditors and preference shareholders are fully met, the equity shareholders 
receive a distribution of profits or assets on liquidation. A measure of his well being is reflected 
by return on equity. There are several other measures to calculate return on shareholders’ equity 
of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per 
share, that is, the amount that they can get on every share held. It is calculated by dividing 
the profits available to the shareholders by number of outstanding shares. The profits 
available to the ordinary shareholders are arrived at as net profits after taxes minus 
preference dividend.
It indicates the value of equity in the market.
EPS =
(ii) Price-Earnings Ratios = P/E Ratio =
(III) Profitability Ratios:
Net Profit Available to the Shareholder
Number of Ordinary Shares Outstanding
Net Profit after Tax
Average Total Shareholders Equity or Net Worth
Net Profit after Tax
Total Capital Employed
Profit Before Interest and Tax
Fixed Assets + Current Assets
Net Profit
Net Sales
Gross Profit
Net Sales
Earnings Before Interest and Taxes
Interest
Marketer ice per Share
EPS
Opening Stock 13.00 Sales (net) 105.00
Purchases 69.00 Closing Stock 15.00
Wages and Salaries 12.00
Other Mfg. Expenses 10.00
Gross Profit 16.00
Total 120.00 Total 120.00
Administrative and Personnel Expenses 1.50 Gross Profit 16.00
Selling and Distribution Expenses 2.00
Depreciation 2.50
Interest 1.00
Net Profit 9.00
Total 16.00 Total 16.00
Income Tax 4.00 Net Profit 9.00
Equity Dividend 3.00
Retained Earning 2.00
Total 9.00 Total 9.00
Market price per equity share = Rs. 20.00
Particulars Amount Particulars Amount
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.00 Cash & Bank 0.20
Unsecured Loans 25.00 Debtors 11.80
Current Liabilities & Provisions 16.00 Inventories 10.60
Pre-paid expenses 0.80
Investments 16.60
Total 100 Total 100
Liabilities Amount Assets Amount
Profit & Loss Account of ABC Co. Ltd. for the year ending on March 31, 2005:
Introduction to Financial Markets
69
(iii) Interest Coverage Ratio =
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The 
lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt 
service capacity of a firm. Financial institutions calculate the average DSCR for the period 
during which the term loan for the project is repayable. The Debt Service Coverage Ratio is 
defined as follows:
Profit after tax + Depreciation + Other Non cash Expenditure + Interest on term loan
Interest on Term Loan + Repayment of term loan
Profitability and operating/management efficiency of a firm is judged mainly by the following 
profitability ratios:
(i) Gross Profit Ratio (%) =                       * 100
(ii) Net Profit Ratio (%) =                    * 100
Some of the profitability ratios related to investments are:   
(iii) Return on Total Assets =
(iv) Return on Capital Employed =
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -Current Liabilities)
(v) Return on Shareholders’ Equity = 
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., 
only after claims of creditors and preference shareholders are fully met, the equity shareholders 
receive a distribution of profits or assets on liquidation. A measure of his well being is reflected 
by return on equity. There are several other measures to calculate return on shareholders’ equity 
of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per 
share, that is, the amount that they can get on every share held. It is calculated by dividing 
the profits available to the shareholders by number of outstanding shares. The profits 
available to the ordinary shareholders are arrived at as net profits after taxes minus 
preference dividend.
It indicates the value of equity in the market.
EPS =
(ii) Price-Earnings Ratios = P/E Ratio =
(III) Profitability Ratios:
Net Profit Available to the Shareholder
Number of Ordinary Shares Outstanding
Net Profit after Tax
Average Total Shareholders Equity or Net Worth
Net Profit after Tax
Total Capital Employed
Profit Before Interest and Tax
Fixed Assets + Current Assets
Net Profit
Net Sales
Gross Profit
Net Sales
Earnings Before Interest and Taxes
Interest
Marketer ice per Share
EPS
Opening Stock 13.00 Sales (net) 105.00
Purchases 69.00 Closing Stock 15.00
Wages and Salaries 12.00
Other Mfg. Expenses 10.00
Gross Profit 16.00
Total 120.00 Total 120.00
Administrative and Personnel Expenses 1.50 Gross Profit 16.00
Selling and Distribution Expenses 2.00
Depreciation 2.50
Interest 1.00
Net Profit 9.00
Total 16.00 Total 16.00
Income Tax 4.00 Net Profit 9.00
Equity Dividend 3.00
Retained Earning 2.00
Total 9.00 Total 9.00
Market price per equity share = Rs. 20.00
Particulars Amount Particulars Amount
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.00 Cash & Bank 0.20
Unsecured Loans 25.00 Debtors 11.80
Current Liabilities & Provisions 16.00 Inventories 10.60
Pre-paid expenses 0.80
Investments 16.60
Total 100 Total 100
Liabilities Amount Assets Amount
Profit & Loss Account of ABC Co. Ltd. for the year ending on March 31, 2005:
68
Page 5


RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
Introduction to Financial Markets
67
RATIO ANALYSIS
Chapter 10
Mere statistics/data presented in the different financial statements do not reveal the true picture 
of a financial position of a firm. Properly analyzed and interpreted financial statements can 
provide valuable insights into a firm’s performance. To extract the information from the financial 
statements, a number of tools are used to analyse such statements. The most popular tool is the 
Ratio Analysis.
Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/ 
Capital structure ratio, and (III) Profitability ratios.
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term 
which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) 
Current Ratio, (ii) Acid Test Ratio, (iii) T urnover Ratios. It is based upon the relationship 
between current assets and current liabilities.
(i) Current Ratio =
The  current  ratio  measures the  ability  of the  firm  to  meet  its current liabilities from 
the current assets.  Higher the current ratio, greater the short-term solvency (i.e. larger is 
the amount of rupees available per rupee of liability).                                                   
(ii) Acid-test Ratio =
Quick assets are defined as current assets excluding inventories and prepaid expenses. The 
acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into 
cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be 
satisfactory.
(iii) T urnover Ratios:
T urnover ratios measure how quickly certain current assets are converted into cash or how 
efficiently the assets are employed by a firm. The important turnover ratios are:
Inventory T urnover Ratio, Debtors T urnover Ratio, Average Collection Period, Fixed Assets 
T urnover and Total Assets T urnover.
Inventory T urnover Ratio = 
Where, the cost of goods sold means sales minus gross profit. ‘ Average Inventory’ refers to 
simple average of opening and closing inventory. The inventory turnover ratio tells the 
efficiency of inventory management. Higher the ratio, more the efficient of inventory 
management.
Debters’ T urnover Ratio =
 
(I) Liquidity Ratios:
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
Cost of Goods Sold
Average Inventory
Net Credit Sales
Average Accounts Receivable (Debtors)
The ratio shows how many times accounts receivable (debtors) turn over during the year. If 
the figure for net credit sales is not available, then net sales figure is to be used. Higher the 
debtors turnover, the greater the efficiency of credit management.
Average Collection Period = 
Average Collection Period represents the number of days’ worth credit sales that is locked 
in debtors (accounts receivable).
Please note that the Average Collection Period and the Accounts Receivable (Debtors) 
Turnover are related as follows:
Average Collection Period =
  
Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other 
words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated 
as follows:
Fixed Assets turnover ratio =
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
Long term financial strength or soundness of a firm is measured in terms of its ability to 
pay interest regularly or repay principal on due dates or at the time of maturity. Such long 
term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly 
there are two sets of ratios: First, the ratios based on the relationship between borrowed 
funds and owner’s capital which are computed from the balance sheet. Some such ratios 
are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated 
from Profit and Loss Account are: The interest coverage ratio and debt service coverage 
ratio are coverage ratio to leverage risk.
(i) Debt-Equity Ratio reflects relative contributions of creditors and owners to finance the 
business.
Debt-Equity Ratio =
The desirable/ideal proportion of the two components (high or low ratio) varies from 
industry to industry.
(ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total 
assets comprise of permanent capital plus current liabilities.
Debt-Asset Ratio =
The second set or the coverage ratios measure the relationship between proceeds from the 
operations of the firm and the claims of outsiders.
(II) Leverage/Capital structure Ratios:
Average Debtors
Average Daily Credit Sales
365 Days
Debtors Turnover
Net Sales
Net Fixed Assets
Net Sales
Average Total Assets
Total Debt
Total Equity
Total Debt
Total Assets
66
(iii) Interest Coverage Ratio =
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The 
lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt 
service capacity of a firm. Financial institutions calculate the average DSCR for the period 
during which the term loan for the project is repayable. The Debt Service Coverage Ratio is 
defined as follows:
Profit after tax + Depreciation + Other Non cash Expenditure + Interest on term loan
Interest on Term Loan + Repayment of term loan
Profitability and operating/management efficiency of a firm is judged mainly by the following 
profitability ratios:
(i) Gross Profit Ratio (%) =                       * 100
(ii) Net Profit Ratio (%) =                    * 100
Some of the profitability ratios related to investments are:   
(iii) Return on Total Assets =
(iv) Return on Capital Employed =
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -Current Liabilities)
(v) Return on Shareholders’ Equity = 
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., 
only after claims of creditors and preference shareholders are fully met, the equity shareholders 
receive a distribution of profits or assets on liquidation. A measure of his well being is reflected 
by return on equity. There are several other measures to calculate return on shareholders’ equity 
of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per 
share, that is, the amount that they can get on every share held. It is calculated by dividing 
the profits available to the shareholders by number of outstanding shares. The profits 
available to the ordinary shareholders are arrived at as net profits after taxes minus 
preference dividend.
It indicates the value of equity in the market.
EPS =
(ii) Price-Earnings Ratios = P/E Ratio =
(III) Profitability Ratios:
Net Profit Available to the Shareholder
Number of Ordinary Shares Outstanding
Net Profit after Tax
Average Total Shareholders Equity or Net Worth
Net Profit after Tax
Total Capital Employed
Profit Before Interest and Tax
Fixed Assets + Current Assets
Net Profit
Net Sales
Gross Profit
Net Sales
Earnings Before Interest and Taxes
Interest
Marketer ice per Share
EPS
Opening Stock 13.00 Sales (net) 105.00
Purchases 69.00 Closing Stock 15.00
Wages and Salaries 12.00
Other Mfg. Expenses 10.00
Gross Profit 16.00
Total 120.00 Total 120.00
Administrative and Personnel Expenses 1.50 Gross Profit 16.00
Selling and Distribution Expenses 2.00
Depreciation 2.50
Interest 1.00
Net Profit 9.00
Total 16.00 Total 16.00
Income Tax 4.00 Net Profit 9.00
Equity Dividend 3.00
Retained Earning 2.00
Total 9.00 Total 9.00
Market price per equity share = Rs. 20.00
Particulars Amount Particulars Amount
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.00 Cash & Bank 0.20
Unsecured Loans 25.00 Debtors 11.80
Current Liabilities & Provisions 16.00 Inventories 10.60
Pre-paid expenses 0.80
Investments 16.60
Total 100 Total 100
Liabilities Amount Assets Amount
Profit & Loss Account of ABC Co. Ltd. for the year ending on March 31, 2005:
Introduction to Financial Markets
69
(iii) Interest Coverage Ratio =
Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The 
lenders use this ratio to assess debt servicing capacity of a firm.
(iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt 
service capacity of a firm. Financial institutions calculate the average DSCR for the period 
during which the term loan for the project is repayable. The Debt Service Coverage Ratio is 
defined as follows:
Profit after tax + Depreciation + Other Non cash Expenditure + Interest on term loan
Interest on Term Loan + Repayment of term loan
Profitability and operating/management efficiency of a firm is judged mainly by the following 
profitability ratios:
(i) Gross Profit Ratio (%) =                       * 100
(ii) Net Profit Ratio (%) =                    * 100
Some of the profitability ratios related to investments are:   
(iii) Return on Total Assets =
(iv) Return on Capital Employed =
(Here, Total Capital Employed = Total Fixed Assets + Current Assets -Current Liabilities)
(v) Return on Shareholders’ Equity = 
(Net worth includes Shareholders’ equity capital plus reserves and surplus)
A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., 
only after claims of creditors and preference shareholders are fully met, the equity shareholders 
receive a distribution of profits or assets on liquidation. A measure of his well being is reflected 
by return on equity. There are several other measures to calculate return on shareholders’ equity 
of which the following are the stock market related ratios:
(i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per 
share, that is, the amount that they can get on every share held. It is calculated by dividing 
the profits available to the shareholders by number of outstanding shares. The profits 
available to the ordinary shareholders are arrived at as net profits after taxes minus 
preference dividend.
It indicates the value of equity in the market.
EPS =
(ii) Price-Earnings Ratios = P/E Ratio =
(III) Profitability Ratios:
Net Profit Available to the Shareholder
Number of Ordinary Shares Outstanding
Net Profit after Tax
Average Total Shareholders Equity or Net Worth
Net Profit after Tax
Total Capital Employed
Profit Before Interest and Tax
Fixed Assets + Current Assets
Net Profit
Net Sales
Gross Profit
Net Sales
Earnings Before Interest and Taxes
Interest
Marketer ice per Share
EPS
Opening Stock 13.00 Sales (net) 105.00
Purchases 69.00 Closing Stock 15.00
Wages and Salaries 12.00
Other Mfg. Expenses 10.00
Gross Profit 16.00
Total 120.00 Total 120.00
Administrative and Personnel Expenses 1.50 Gross Profit 16.00
Selling and Distribution Expenses 2.00
Depreciation 2.50
Interest 1.00
Net Profit 9.00
Total 16.00 Total 16.00
Income Tax 4.00 Net Profit 9.00
Equity Dividend 3.00
Retained Earning 2.00
Total 9.00 Total 9.00
Market price per equity share = Rs. 20.00
Particulars Amount Particulars Amount
Illustration:
Balance Sheet of ABC Co. Ltd. as on March 31, 2005
(Rs. in Crore)
Share Capital 16.00 Fixed Assets (net) 60.00
(1,00,00,000 equity shares of Rs.10 each)
Reserves & Surplus 22.00 Current Assets: 23.40
Secured Loans 21.00 Cash & Bank 0.20
Unsecured Loans 25.00 Debtors 11.80
Current Liabilities & Provisions 16.00 Inventories 10.60
Pre-paid expenses 0.80
Investments 16.60
Total 100 Total 100
Liabilities Amount Assets Amount
Profit & Loss Account of ABC Co. Ltd. for the year ending on March 31, 2005:
68
Current Ratio = Current Assets / Current Liabilities 
= 23.40/16.00 = 1.46
Quick Ratio = Quick Assets / Current Liabilities
= Current Assets-(inventory + prepaid expenses)/Current Liabilities
= [23.40-(10.60+0.8)]/16.00 = 12.00/16.00 = 0.75
Inventory Turnover Ratio = Cost of goods sold/Average Inventory
= (Net Sales-Gross Profit)/ [(opening stock+ closing stock)/2] 
= (105-16)/ [(15+13)/2] = 89/14 = 6.36
Debtors Turnover Ratio = Net Sales/ Average account receivables (Debtors)
= 105/11.80 =8.8983
Average Collection Period = 365 days / Debtors turnover 
= 365 days/8.8983 = 41 days
Fixed Assets Turnover Ratio = Net Sales / Net Fixed Assets 
= 105/60 = 1.75
Debt to Equity Ratio = Debt/ Equity
= (21.00+25.00)/ (16.00+22.00) = 46/38 = 1.21
Gross Profit Ratio = Gross Profit/Net Sales 
= 16.00/105.00 = 0.15238 or 15.24%
Net Profit Ratio = Net Profit / Net Sales 
= 9/105.00 = 0.0857 or 8.57 %
Return on Shareholders’ Equity = Net Profit after tax/Net worth 
= 5.00/(16.00+22.00) =0.13157 or 13.16%
Abbreviations:
NSE- National Stock Exchange of India Ltd.
SEBI - Securities Exchange Board of India 
NCFM - NSE’s Certification in Financial Markets
NSDL - National Securities Depository Limited
CSDL - Central Depository Services (India) Limited
NCDEX - National Commodity and Derivatives Exchange Ltd.
NSCCL - National Securities Clearing Corporation Ltd.
FMC - Forward Markets Commission
NYSE- New York Stock Exchange
AMEX - American Stock Exchange
OTC- Over-the-Counter Market
LM - Lead Manager
IPO- Initial Public Offer
DP - Depository Participant
DRF - Demat Request Form
RRF - Remat Request Form
NAV - Net Asset Value
EPS - Earnings Per Share
DSCR - Debt Service Coverage Ratio
S&P - Standard & Poor
IISL - India Index Services &. Products Ltd
CRISIL- Credit Rating Information Services of India Limited
CARE - Credit Analysis & Research Limited
ICRA - Investment Information and Credit Rating Agency of India
ISC - Investor Service Cell IPF - Investor Protection Fund
SCRA - Securities Contract (Regulation) Act
SCRR - Securities Contract (Regulation) Rules
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Introduction to Financial Markets
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