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Financial Ratios
Financial Ratio Analysis is a study of relationship
among various factors in a business
It can be used as a preliminary screening tool for
the assessment of a stock or future financial
condition and hence result for a company
Most importantly these ratios are used from the
perspectives of credit rating agency(debt
instruments) , equity research firm(equity growth)
and shareholders or investors(financial health) and
Managers

Types of Financial Ratios

Liquidity
Measurement

Profitability
Indicators

Financial Leverage

Operating
Performance

Investment
Valuation

Current Ratio

Profit Margin
Analysis

Debt Ratio

Fixed Assets
Turnover

Price/Earnings
Ratio

Quick Ratio

Return on
Assets

Debt-Equity Ratio

Sales/ Revenue

Price/Earnings
to Growth
ratio

Return on
Equity

Capitalization
Ratio

Return on
Capital
Employed

Average Collection Dividend Yield

Period

Interest Coverage Inventory Turnover

Ratio
Total assets
Turnover

Dividend
Payout Ratio

Liquidity Ratios
Liquidity refers to the ability of a firm to meet its
short-term financial obligations when and as they
fall due.
The main concern of liquidity ratio is to measure the
ability of the firms to meet their short-term
maturing obligations.
The greater the coverage of liquid assets to shortterm liabilities the better as it is a clear signal that a
company can pay its debts that are coming due in
the near future and still fund its ongoing operations.

Current Ratio
Formula
Current Assets / Current Liabilities
Current assets includes cash, marketable securities, accounts receivable and
inventories.
Current liabilities includes accounts payable, short term notes payable, shortterm loans, current maturities of long term debt, accrued income taxes and
other accrued expenses

Meaning
The number of times that the short term assets can cover the short term debts.
In other words, it indicates an ability to meet the short term obligations as &
when they fall due

Analysis
Higher the ratio, the better it is, however but too high ratio reflects an inefficient use of resources & too low ratio leads to insolvency. The ideal ratio is
considered to be 2:1.,

Quick Ratio
Formula
(Cash + Cash Equivalents + Short Term Investments +
Accounts Receivables) / Current Liabilities

Meaning
Indicates the ability to meet short term payments using the
most liquid assets. This ratio is more conservative than the
current ratio because it excludes inventory and other current
assets, which are more difficult to turn into cash

Analysis
The ideal ratio is 1:1. Another beneficial use is to compare the
quick ratio with the current ratio. If the current ratio is
significantly higher, it is a clear indication that the company's
current assets are dependent on inventory.

Profitability Ratios
Profitability is the ability of a business to earn
profit over a period of time
The profitability ratios show the combined
effects of liquidity, asset management (activity)
and debt management (gearing/leverage) on
operating results.
The overall measure of success of a business is
the profitability which results from the effective
use of its resources.
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Profitability Ratios
Margins
Gross profit margin
Operating profit margin
Net profit margin

Returns
Return on assets
Return on equity
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Gross Profit Margin

Formula
(Gross Profit/Net Sales)*100

Meaning
A company's cost of goods sold represents the expense related
to labor,raw materials and manufacturing overhead involved in
its production process. This expense is deducted from the
company's net sales/revenue, which results in a company's
gross profit. The gross profit margin is used to analyze how
efficiently a company is using its raw materials, labor and
manufacturing-related fixed assets to generate profits.

Analysis
Higher the ratio, the higher is the profit earned on sales
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Operating Profit Margin

Formula
(Operating Profit/Net Sales)*100

Meaning
By subtractingselling, general and administrative
expenses from a company's gross profit number, we get
operating income. Management has much more control
over operating expenses than its cost of sales outlays. It
Measures the relative impact of operating expenses

Analysis
Lower the ratio, higher the expense related to the sales
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Net Profit Margin

Formula
(Net Profit/Net Sales)*100

Meaning
This ratio measures the ultimate profitability

Analysis
Higher the ratio, the more profitable are the
sales.
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Return on Assets(ROA)

Formula
(Net Income + Interest (1-t))/ Total Assets

Meaning
This ratio illustrates how well management is
employing the company's total assets to make a
profit

Analysis
Higher the return, the more efficient management is
in utilizing its asset base
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Return on Equity(ROE)

Formula
Net Income / Shareholders Equity

Meaning
It measures how much the shareholders earned for
their investment in the company

Analysis
Higher percentage indicates the management is in
utilizing its equity base and the better return is to
investors
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Return on Capital
Employed(ROCE)
Formula
(Net Income + Interest (1-t))/ Capital Employed
Capital Employed = Long term Liabilities + Shareholders Equity

Meaning
This ratio complements thereturn on equity ratio by adding a company's
debt liabilities, or funded debt, to equity to reflect a company's total "capital
employed". This measure narrows the focus to gain a better understanding
of a company's ability to generate returns from its available capital base.

Analysis
It is a more comprehensive profitability indicator because it gauges
management's ability to generate earnings from a company's total pool of
capital

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Financial Leverage Ratios

These ratios indicate the degree to which the activities of a firm are
supported by creditors funds as opposed to owners as the relationship
of owners equity to borrowed funds is an important indicator of
financial strength.
The debt requires fixed interest payments and repayment of the loan
and legal action can be taken if any amounts due are not paid at the
appointed time.
A relatively high proportion of funds contributed by the owners
indicates a cushion (surplus) which shields creditors against possible
losses from default in payment.
Financial leverage will be to the advantage of the ordinary shareholders
as long as the rate of earnings on capital employed is greater than the
rate payable on borrowed funds.
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Debt Equity Ratio

Formula
Total Liabilities / Total Equity
Sometimes only interest-bearing, long-term debt is used instead of
total liabilities in the calculation

Meaning
This ratio measures how much suppliers, lenders, creditors and obligors
have committed to the company versus what the shareholders have
committed.
This ratio indicates the extent to which debt is covered by shareholders
funds.

Analysis
A lower ratio is always safer, however too low ratio reflects an in-efficient
use of equity. Too high ratio reflects either there is a debt to a great extent
or the equity base is too small

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Debt Ratio

Formula
Total Debt / Total Assets

Meaning
This compares a company's totaldebt to its total assets, which is used to
gain a general idea as to the amount of leverage being used by a company.
This is the measure of financial strength that reflects the proportion of
capital which has been funded by debt, including preference shares

Analysis
With higher debt ratio (low equity ratio), a very small cushion has
developed thus not giving creditors the security they require. The company
would therefore find it relatively difficult to raise additional financial support
from external sources if it wished to take that route. The higher the debt
ratio the more difficult it becomes for the firm to raise debt

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Capitalization Ratio

Formula
Long Term Debt / (Long Term Debt + Shareholders Equity)

Meaning
This ratio measures the debt component of a company's capital structure, or
capitalization (i.e., the sum of long-term debtliabilities and shareholders' equity)
to support a company's operations and growth

Analysis
A low level of debt and a healthy proportion of equity in a company's capital
structure is an indication of financial fitness
A company too highly leveraged (too much debt) may find its freedom of action
restricted by its creditors and/or have its profitability hurt by high interest costs.
This ratio is one of the more meaningful debt ratios because it focuses on the
relationship of debt liabilities as a component of a company's total capital base,
which is the capital raised by shareholders and lenders

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Interest Coverage Ratio

Formula
EBIT / Interest Expense

Meaning
This ratio measures the number of times a company can meet
its interest expense

Analysis
The lower the ratio, the more the company is burdened by debt
expense. When a company's interest coverage ratio is only 1.5
or lower, its ability to meet interest expenses may be
questionable

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Operating Performance Ratios

These ratios look at how well a company

turns its assets into revenue as well as how
efficientlya company converts its sales into
cash, i.e. how efficiently & effectively a
company is using its resources to generate
sales and increase shareholder value.
The better these ratios, the better it is for
shareholders.
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Fixed Assets Turnover

Formula
Sales / Net Fixed Assets

Meaning
This ratio is a rough measure of the productivity of a
company'sfixed assets with respect to generating
sales

Analysis
High fixed assets turnovers are preferred since they
indicate a better efficiency in fixed assets utilization.

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Inventory Turnover

Formula
Sales / Average Inventory Investopedia
Also calculated as COGS/Average Inventory

Meaning
It measures the stock in relation to turnover in order to
determine how often the stock turns over in the business.
It indicates the efficiency of the firm in selling its product.

Analysis
High ratio indicates that there is a little chance of the firm
holding damaged or obsolete stock.

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Days Sales Outstanding(DSO)

Formula
(Accounts Receivable / Annual Credit Sales)*365 days

Meaning
DSO measures the quality of debtors since it indicates the speed of their
collection

Analysis
The shorter the DSO, the better the quality of debtors, as a short
collection period implies the prompt payment by debtors. An excessively
long collection period implies a very liberal and inefficient credit and
collection performance. The delay in collection of cash impairs the firms
liquidity. On the other hand, too low a collection period is not necessarily
favorable, rather it may indicate a very restrictive credit and collection
policy which may curtail sales and hence adversely affect profit.

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Investment Valuation Ratios

These ratios can be used by investors to

estimate the attractiveness of a potential
or existing investment and get an idea of
its valuation.
The most important class of ratios for an
external investor evaluating a stock or a
company

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Price to Earning Ratio ( P/E Ratio)

Formula
Market Price per Share / Earnings Per Share

Meaning
This ratio measures how many times a stock is trading (its price) per
each rupee of EPS

Analysis
A stock with high P/E ratio suggests that investors are expecting higher
earnings growth in the future compared to the overall market, as
investors are paying more for today's earnings in anticipation of future
earnings growth. Hence, stocks with this characteristic are considered
to be growth stocks
Conversely, a stock with a low P/E ratio suggests that investors have
more modest expectations for its future growth compared to the
market as a whole
However, a stock trading at higher P/E than the average P/E of the
industry may also suggest that the stock is overpriced and is due for a25
correction

Price to Book Value Ratio ( P/B Ratio )

Formula
Market Price per Share / Book Value of Equity per share

Meaning
A ratio used to compare a stock's market value to its book value. It is
calculated by dividing the current closing price of the stock by the
latest quarter's book value per share

Analysis
A lower P/B ratio could mean that the stock is undervalued. However, it
could also mean that something is fundamentally wrong with the
company. As with most ratios, be aware that this varies by industry
This ratio also gives some idea of whether you're paying too much for
what would be left if the company went bankrupt immediately

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Price to Sales Ratio ( P/S Ratio )

Formula
Market Price per Share / Revenue per share

Meaning
A ratio for valuing a stock relative to its own past performance, other
companies or the market itself. Price to sales is calculated by dividing a
stock's current price by its revenue per share for the trailing 12
months:

Analysis
The price-to-sales ratio can vary substantially across industries;
therefore, it's useful mainly when comparing similar companies.
Because it doesn't take any expenses or debt into account, the ratio is
somewhat limited in the story it tells.

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Price Earnings to Growth

Ratio(PEG)
Formula
( P/E Ratio ) / Earnings Growth

Meaning
The price/earnings to growth ratio, commonly referred to as the PEG ratio, is obviously closely
related to the P/E ratio. The PEG ratio is a refinement of the P/E ratio and factors in a stock's
estimated earnings growth into its current valuation. By comparing a stock's P/E ratio with its
projected, or estimated,earnings per share (EPS) growth, investors are given insight into the
degree of overpricing or under pricing of a stock's current valuation, as indicated by the
traditional P/E ratio

Analysis
The general consensus is that if the PEG ratio indicates a value of 1, this means
that the market is correctly valuing (the current P/E ratio) a stock in accordance
with the stock's current estimated earnings per share growth. If the PEG ratio is
less than 1, this means that EPS growth is potentially able to surpass the
market's current valuation. In other words, the stock's price is being
undervalued. On the other hand, stocks with high PEG ratios can indicate just the
opposite- that the stock is currently overvalued.

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Dividend Yield Ratio

Formula
( Annual Dividend per Share / Market Price per Share )

Meaning
This ratio allows investors to compare the latest dividend
they received with the current market value of the share as
an indictor of the return they are earning on their shares

Analysis
This enables an investor to compare ratios for different
companies and industries. Higher the ratio, the higher is the
return to the investor

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Dividend Payout Ratio

Formula
(Dividend per Share / Earnings per Share )

Meaning
This ratio identifies the percentage of earnings (net
income) per common share allocated to paying
cashdividends to shareholders. Thedividend payout
ratio is an indicator of how well earnings support the
dividend payment.

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Enterprise Multiple (EV/EBITDA)

Formula
Enterprise Value/EBITDA

Meaning
A ratio used to determine the value of a company. The enterprise multiple
looks at a firm as a potential acquirer would, because it takes debt into
account - an item which other multiples like the P/E ratio do not include

Analysis
It's useful for transnational comparisons because it ignores the distorting
effects of individual countries' taxation policies.
It's used to find attractive takeover candidates. Enterprise value is a better
metric than market cap for takeovers. It takes into account the debt which
the acquirer will have to assume. Therefore, a company with a low
enterprise multiple can be viewed as a good takeover candidate.
Expect higher enterprise multiples in high growth industries (like biotech)
and lower multiples in industries with slow growth (like railways)
A low ratio indicates that a company might be undervalued
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Other Important Terms and Equations

Du-Point Equation
Cash Conversion Cycle (CCC)
Working Capital
Sustainable Growth Rate
Free Cash Flow to Firm(FCFF)
Free Cash Flow to Equity (FCFE)

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Du-Point Equation

Formula

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover

(Sales/Assets) * Equity Multiplier (Assets/Equity)

Meaning

DuPont analysis tells us that ROE is affected by three things:

1) Operating efficiency, which is measured by profit margin
2) Asset use efficiency, which is measured by total asset turnover
3) Financial leverage, which is measured by the equity multiplier

Analysis

It is believed that measuring assets at gross book value removes the

incentive to avoid investing in new assets. New asset avoidance can
occur as financial accounting depreciation methods artificially produce
lower ROEs in the initial years that an asset is placed into service. If
ROE is unsatisfactory, the DuPont analysis helps locate the part of the
business that is underperforming.
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Cash Conversion Cycle

Formula
CCC=DIO+DSO-DPO
DIO represents days inventory outstanding
DSO represents days sales outstanding
DPO represents days payable outstanding

Meaning
A metric that expresses the length of time, in days, that it takes for a
company to convert resource inputs into cash flows.
It looks at the amount of time needed to sell inventory, the amount of
time needed to collect receivables and the length of time the company
is afforded to pay its bills without incurring penalties.

Analysis
This cycle is extremely important for retailers and similar businesses. It
illustrates how quickly a company can convert its products into cash
through sales.
The shorter the cycle, the less time capital is tied up in the business
process, and thus the better for the company's bottom line
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Working Capital

Formula

Working Capital = Current Assets Current Liabilities

Meaning

If a company's current assets do not exceed its current

liabilities, then it may run into trouble paying back creditors in
the short term. The worst-case scenario is bankruptcy. A
declining working capital ratio over a longer time period could
also be a red flag that warrants further analysis. For example,
it could be that the company's sales volumes are decreasing
and, as a result, its accounts receivables number continues to
get smaller and smaller

Analysis

This ratio indicates whether a company has enough short term

assets to cover its short term debt. Anything below 1 indicates
negative W/C (working capital). While anything over 2 means
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that the company is not investing excess assets. Most believe

Sustainable Growth Rate

Formula

ROE x Retention Ratio

Retention Ratio = (1 Dividend Payout Ratio)

Meaning

The maximum growth rate that a firm can sustain without having to
increase financial leverage.

Analysis

The sustainable growth rate is a measure of how much a firm can grow
without borrowing more money. After the firm has passed this rate, it
must borrow funds from another source to facilitate growth.

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Free Cash Flow to the Firm(FCFF)

Formula
FCFF= Net Income + Depreciation + Interest(1-Tax Rate)
Change in Working Capital Net Capex
Meaning
A measure of financial performance that expresses the net amount of
cash that is generated for the firm, consisting of expenses, taxes and
changes in net working capital and investments.
Analysis
This is a measurement of a company's profitability after all expenses
and reinvestments. It's one of the many benchmarks used to compare
and analyse financial health
A positive value would indicate that the firm has cash left after
expenses. A negative value, on the other hand, would indicate that the
firm has not generated enough revenue to cover its costs and
investment activities
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Free Cash Flow to the Equity(FCFE)

Formula
FCFE = Net Income - Net Capital Expenditure - Change in Net
Working Capital + New Debt - Debt Repayment

Meaning
This is a measure of how much cash can be paid to the equity
shareholders of the company after all expenses, reinvestment and debt
repayment.

Analysis
FCFE is often used by analysts in an attempt to determine the value of a
company
This alternative method of valuation gained popularity as the dividend
discount model's usefulness became increasingly questionable
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Example - Granules India

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Thank
You
Akanksha Gupta
Alapati Mahesh
Amaresh Krishna

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+91-9703148254
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