Ratio Analysis

Liquidity Ratios

Liquidity ratios measure an organisation's ability to meet its short-term obligations as they fall due. They help assess whether current assets are sufficient to cover current liabilities. These ratios are particularly important for banks, agribusinesses, and any firm where working capital management is critical.

• Quick Ratio
• Current Ratio
• Cash Ratio

Current Ratio

The Current Ratio shows the relationship between total current assets and total current liabilities.

Formula: Current Ratio = Current Assets ÷ Current Liabilities

Interpretation: A ratio of 2:1 is a conventional benchmark for many manufacturing and trading firms, but acceptable norms vary by industry. A higher ratio indicates better short-term solvency; an excessively high ratio may indicate inefficient use of assets.

Example: Calculate the current ratio when current assets are ₹3,00,000 and current liabilities are ₹1,50,000.

Current Assets = ₹3,00,000 Current Liabilities = ₹1,50,000 Current Ratio = 3,00,000 ÷ 1,50,000 Current Ratio = 2.0

Quick Ratio (Acid-test Ratio)

The Quick Ratio measures the ability to meet short-term obligations with the most liquid current assets, excluding inventory.

Formula: Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities

Interpretation: A value of 1:1 is often used as a rough benchmark. This ratio is useful where inventory is not readily convertible to cash (for example, seasonal agricultural inventory).

Cash Ratio

The Cash Ratio is the most conservative liquidity measure; it considers only cash and cash equivalents against current liabilities.

Formula: Cash Ratio = (Cash + Cash Equivalents) ÷ Current Liabilities

Interpretation: Values are typically below 1. A higher cash ratio indicates strong liquidity but may also suggest idle cash that could be invested for returns.

Turnover Ratios

Turnover ratios (also called activity ratios) show how efficiently a company uses its assets and manages payables and receivables. They are important to evaluate operating efficiency and working capital cycle.

• Accounts Payable Turnover Ratio
• Accounts Receivable Turnover Ratio
• Inventory Turnover Ratio
• Days Payable Outstanding
• Assets Turnover Ratio
• Working Capital Turnover Ratio

Accounts Receivable Turnover Ratio

This ratio measures how quickly a firm collects cash from credit sales.

Formula: Accounts Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable

Interpretation: A higher turnover indicates efficient collection. For banks and agribusiness traders that extend credit, a low turnover may signal collection problems.

Inventory Turnover Ratio

This ratio shows how many times inventory is sold and replaced during a period.

Formula: Inventory Turnover = Cost of Goods Sold (COGS) ÷ Average Inventory

Interpretation: Higher turnover means faster movement of stock. For agricultural produce, turnover can be seasonal and must be compared with standard industry cycles.

Example: Compute inventory turnover when COGS = ₹12,00,000 and average inventory = ₹2,00,000.

Cost of Goods Sold = ₹12,00,000 Average Inventory = ₹2,00,000 Inventory Turnover = 12,00,000 ÷ 2,00,000 Inventory Turnover = 6 times

Accounts Payable Turnover Ratio

This indicates how quickly a firm pays its suppliers.

Formula: Accounts Payable Turnover = Purchases ÷ Average Accounts Payable

Interpretation: A lower turnover implies slower payments (extended credit from suppliers); a higher turnover means faster payment. Days Payable Outstanding converts this into days.

Days Payable Outstanding (DPO)

Formula: DPO = (Average Accounts Payable ÷ Purchases) × Number of Days

Interpretation: DPO indicates average days a firm takes to pay suppliers. It is used together with inventory days and receivable days to measure the cash conversion cycle.

Assets Turnover Ratio

This ratio measures how efficiently total assets generate revenue.

Formula: Assets Turnover = Net Sales ÷ Average Total Assets

Interpretation: Higher values indicate more efficient use of assets to produce sales.

Working Capital Turnover Ratio

This ratio shows how efficiently a company uses its working capital to generate revenue.

Formula: Working Capital Turnover = Net Sales ÷ Average Working Capital

Interpretation: Very high values may suggest insufficient working capital; low values indicate under-utilisation.

Profitability Ratios

Profitability ratios assess the ability of an organisation to generate earnings relative to sales, assets or equity. These ratios are primary indicators of financial health for investors, bankers and managers.

• Return on Equity (ROE)
• Return on Capital Employed (ROCE)
• Return on Asset (ROA) Ratio
• Pretax Profit Ratio
• Price Earning to Growth (PEG) Ratio
• Price Earnings (PE) Ratio
• Price to Book Value (PB) Ratio
• Operating Ratio
• Operating Profit Ratio
• Net Profit Ratio
• Gross Profit Ratio
• Earnings Per Share Ratio
• Dividend Payout Ratio

Gross Profit Ratio

Formula: Gross Profit Ratio = Gross Profit ÷ Net Sales

Interpretation: Indicates the proportion of sales remaining after covering direct production costs. Higher ratio suggests better production efficiency or pricing power.

Operating Profit Ratio

Formula: Operating Profit Ratio = Operating Profit ÷ Net Sales

Interpretation: Measures efficiency of core business operations before financing and taxes.

Net Profit Ratio (Net Profit Margin)

Formula: Net Profit Ratio = Net Profit After Tax ÷ Net Sales

Interpretation: Shows the percentage of revenue converted into profit after all expenses. Useful for comparing firms in the same sector.

Return on Assets (ROA)

Formula: ROA = Net Income ÷ Average Total Assets

Interpretation: Indicates how efficiently assets are used to generate profit. Higher ROA is generally better.

Return on Equity (ROE)

Formula: ROE = Net Income ÷ Average Shareholders' Equity

Interpretation: Measures return earned on shareholders' funds. It is a key metric for equity investors.

Return on Capital Employed (ROCE)

Formula: ROCE = Earnings Before Interest and Tax (EBIT) ÷ Capital Employed

Interpretation: Shows the returns generated from capital used in business operations; useful to compare with cost of capital.

Price-Earnings (PE) Ratio

Formula: PE Ratio = Market Price per Share ÷ Earnings per Share (EPS)

Interpretation: Indicates how much investors are willing to pay per rupee of earnings. Higher PE can imply growth expectations; it must be compared within industries.

Price to Book Value (PB) Ratio

Formula: PB Ratio = Market Price per Share ÷ Book Value per Share

Interpretation: Compares market valuation with accounting value; PB less than 1 may indicate undervaluation or structural problems.

PEG Ratio

Formula: PEG = PE Ratio ÷ Annual Earnings Growth Rate

Interpretation: Adjusts PE for growth; values around 1 are often considered fair, but interpretation varies by sector.

Earnings Per Share (EPS)

Formula: EPS = (Net Income - Preferred Dividends) ÷ Weighted Average Number of Ordinary Shares

Interpretation: Fundamental per-share profitability metric used to compute PE and track earnings trends.

Dividend Payout Ratio

Formula: Dividend Payout Ratio = Dividends per Share ÷ Earnings per Share

Interpretation: Shows proportion of earnings distributed as dividends. A balance is needed between rewarding shareholders and retaining earnings for growth.

Solvency Ratios

Solvency ratios assess an organisation's long-term viability and its ability to meet long-term obligations. These ratios are critical for lenders, investors and regulators.

• Debt to Asset Ratio
• Proprietary Ratio
• Interest Coverage Ratio
• Debt to Capital Ratio
• Debt Service Coverage Ratio
• Debt-Equity Ratio
• Capital Gearing Ratio

Debt-Equity Ratio

Formula: Debt-Equity Ratio = Total Debt ÷ Shareholders' Equity

Interpretation: Indicates the relative proportion of debt and equity financing. A lower ratio is generally safer, though acceptable levels vary by industry and business model.

Debt to Asset Ratio

Formula: Debt to Asset Ratio = Total Debt ÷ Total Assets

Interpretation: Shows the proportion of assets financed by debt. Values closer to 1 indicate higher leverage and risk.

Interest Coverage Ratio

Formula: Interest Coverage = Earnings Before Interest and Tax (EBIT) ÷ Interest Expense

Interpretation: Measures the ability to meet interest payments. A ratio below 1.5 may signal difficulty in servicing debt.

Debt Service Coverage Ratio (DSCR)

Formula: DSCR = Net Operating Income ÷ Total Debt Service (principal + interest)

Interpretation: Used by lenders to check whether operating income can cover scheduled debt repayments.

Proprietary Ratio

Formula: Proprietary Ratio = Shareholders' Funds ÷ Total Assets

Interpretation: Indicates the proportion of total assets financed by owners' equity rather than creditors.

Capital Gearing Ratio

This ratio compares fixed interest-bearing capital to equity capital and indicates financial risk arising from fixed obligations.

Ratio analysis is a vital tool for financial analysis, risk assessment and decision making. It becomes most powerful when ratios are used together, interpreted in the context of industry norms, adjusted for accounting differences, and supported by qualitative information about the business environment. Regular practice on real financial statements will build skill in selecting relevant ratios and interpreting them correctly.