Ratio Analysis

Ratio Analysis
Introduction to Ratio Analysis

Ratio analysis can be defined as the process of ascertaining the financial
ratios that are used for indicating the ongoing financial performance of a
company using few types of ratios such as liquidity, profitability, activity,
debt, market, solvency, efficiency, and coverage ratios and few examples of
such ratios are return on equity, current ratio, quick ratio, dividend payout
ratio, debt-equity ratio, and so on.
Ratio analysis is a process used for the calculation of financial ratios or in
other words, for the purpose of evaluating the financial wellbeing of a
company. The values used for the calculation of financial ratios of a
company are extracted from the financial statements of that same
company.
Types of Ratio Analysis
Types of ratios are given below:
1. Liquidity Ratios
This type of ratio helps in measuring the ability of a company to take care
of its short-term debt obligations. A higher liquidity ratio represents that
the company is highly rich in cash.
The types of liquidity ratios are: –
1. Current Ratio: The current ratio is the ratio between the current assets
and current liabilities of a company. The current ratio is used to indicate the
liquidity of an organization in being able to meet its debt obligations in the
upcoming twelve months. A higher current ratio will indicate that the
organization is highly capable of repaying its short-term debt obligations.
Current Ratio = Current Assets / Current Liabilities
2. Quick Ratio: The quick ratio is used to ascertain information pertaining
to the capability of a company in paying off its current liabilities on an
immediate basis.
The formula used for the calculation of a quick ratio is-
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities +
Accounts Receivables) / Current Liabilities
2. Profitability Ratios
This type of ratio helps in measuring the ability of a company in earning
sufficient profits.
The types of profitability ratios are: –
1. Gross Profit Ratios: Gross profit ratios are calculated in order to
represent the operating profits of an organization after making necessary
adjustments pertaining to the COGS or cost of goods sold.
The formula used for the calculation of gross profit ratio is-
Gross Profit Ratio = (Gross Profit / Net Sales) * 100
2. Net Profit Ratio: Net profit ratios are calculated in order to determine
the overall profitability of an organization after reducing both cash and
non-cash expenditures.
The formula used for the calculation of net profit ratio is-
Net Profit Ratio = (Net Profit / Net Sales) * 100
3. Operating Profit Ratio: Operating profit ratio is used to determine the
soundness of an organization and its financial ability to repay all the short
term and long term debt obligations.
The formula used for the calculation of operating profit ratio is-
Operating Profit Ratio = (Earnings Before Interest and Taxes / Net
Sales) * 100
4. Return on Capital Employed (ROCE): Return on capital employed is
used to determine the profitability of an organization with respect to the
capital that is invested in the business.
The formula used for the calculation of ROCE is:
ROCE = Earnings Before Interest and Taxes / Capital Employed
3. Solvency Ratios
Solvency ratios can be defined as a type of ratio that is used to evaluate
whether a company is solvent and well capable of paying off its debt
obligations or not.
The types of solvency ratios are: –
1. Debt Equity Ratio: The debt-equity ratio can be defined as a ratio
between total debt and shareholders fund. The debt-equity ratio is used to
calculate the leverage of an organization. An ideal debt-equity ratio for an
organization is 2:1.
The formula for debt-equity ratio is-
Debt Equity Ratio = Total Debts / Shareholders Fund
2. Interest Coverage Ratio: The interest coverage ratio is used to
determine the solvency of an organization in the nearing time as well as
how many times the profits earned by that very organization were capable
of absorbing its interest-related expenses.
The formula used for the calculation of interest coverage ratio is-
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest
Expense
4. Turnover Ratios
Turnover ratios are used to determine how efficiently the financial assets
and liabilities of an organization have been used for the purpose of
generating revenues.
The types of turnover ratios are: –
1. Fixed Assets Turnover Ratios: Fixed assets turnover ratio is used to
determine the efficiency of an organization in utilizing its fixed assets for
the purpose of generating revenues.
The formula used for the determination of fixed assets turnover ratio is-
Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets
2. Inventory Turnover Ratio: Inventory turnover ratio is used to determine
the speed of a company in converting its inventories into sales.
The formula used for calculating inventory turnover ratio is-
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
3. Receivable Turnover Ratio: Receivable turnover ratio is used to
determine the efficiency of an organization in collecting or realizing its
account receivables.
The formula used for calculating the receivable turnover ratio is-
Receivables Turnover Ratio = Net Credit Sales / Average Receivables
5. Earnings Ratios
Earnings ratio is used for the purpose of determining the returns that an
organization generates for its investors.
The types of earnings ratios are: –
1. Profit Earnings Ratio: P/E ratio indicates the profit earning capacity of
the company.
The formula used for the calculation of profit earnings ratio is:
Profit Earnings Ratio = Market Price per Share / Earnings per Share
2. Earnings per Share (EPS): EPS signifies the earnings of an equity holder
based on each share.
The formula used for EPS is:
EPS = (Net Income – Preferred Dividends) / (Weighted Average of
Outstanding Shares)
Conclusion – Ratio Analysis Types
Ratio analysis lays the framework for financial analysis. Ratio analysis is also
used by the readers of the financial statements for gaining a better
understanding of the wellbeing of a company. A few basic types of ratios
used in ratio analysis are profitability ratios, debt or leverage ratios, activity
ratios or efficiency ratios, liquidity ratios, solvency ratios, earnings ratios,
turnover ratios, and market ratios.
Ratio analysis primarily aims to compare various line items of the financial
statement pertaining to a business. It is targeted to evaluate various metrics
required to understand a company’s performance like solvency, liquidity,
profitability, and operations efficiency. This is particularly helpful for
analysts outside the company as it is only the financial statement which
they have to study or understand the company. On the other hand,
corporate insiders who have ample information about the company ratio
analysis are not that important.
Objectives of Ratio Analysis

Once an organization’s financial statements are compiled, they need to be
evaluated or analyzed. The objectives of ratio analysis are as follows:
1. Helps in Measuring the Profitability of the

Company
Profit is the key requirement of every business. It is based on profit a
business survives and plans for further expansion. Thus if we say a business
has earned a certain amount of profit, we are not sure how good or bad the
figure is. Thus, here a profitability ratio that includes gross profit, net profit,
Expense ratios comes in handy as it provides the profitability of the firm.
The management can track down the grey areas and work upon them for
improvement.
2. Helps in Evaluating Operational Efficiency

Few of the ratios are targeted to evaluate the firm’s degree of efficiency at
how it is handling its assets and other resources. It is a must for a firm that
assets and financial resources are well utilized, and unnecessary expense
levels are kept to a bare minimum. To get an overall picture of the
efficiency of assets, turnover ratios and efficiency ratios can play a major
role.
3. Maintaining Liquidity
The liquidity problem is the major issue that many firms face these days,
and thus every firm should maintain a certain amount of liquidity to meet
its urgent cash requirement. Specifically to main short term solvency issues,
4. Determining Financial Health

Some ratios are handy to determine the overall financial health and
performance of a company. This can be indicated by determining the
overall long term solvency of the firm. This helps in judging whether there
is too much pressure on the assets or if the firm is over-leveraged. Thus, to
avoid future liquidation problem, the business has to quickly recognize this.
Ratios that prove handy in such scenarios are leverage ratios and debt-
equity ratios.
5. Helps in Comparing
Here, certain ratios are used to compare the benchmarks prevalent in the
industry to get a better outlook of the company’s financial performance
and position. Businesses can take rectifying actions if the company does
not maintain the standard. Here generally, the ratios are compared to the
previous year’s ratio to understand the company’s track record.
Limitations of Ratio Analysis

Ratio analysis is an important aspect; however, a range of drawbacks of
ratio analysis are listed below.
1. Use of Historical Data

All the information used in ratio analysis is based on historical numbers
only. These data are drawn from historical actuals and by no means will
remain the same in the future as business performance changes with every
passing time.
2. The Concept of Inflation

When we compare period-wise numbers for trend analysis, and if the
inflationary rate has changed in between the periods, the comparison
makes no sense. Ratio analysis does not account for the inflation factor at
all.
3. The Problem of Aggregation

The data from the financial statement for a particular line item that we are
using for our study or comparison may have been aggregated in a different
proportion in the past, and thus doing a trend analysis based on this data
doesn’t give a true picture.
4. Changes in Operation
A business can go drastic changes in its operations due to certain
unexpected needs, and thus using the data of the past and making a
judgment based on that does not give a fruitful conclusion because pre-
change and post-change of operation numbers under no circumstances can
be compared together.
5. The Policies of Accounting

When we are doing peer to peer comparison, different companies may use
different accounting policies and thus, it makes it hard to conclude on such
cases.
6. No Standard Definition of Ratios

There is no set standard definition of ratios and numbers to be included in
it. Some firms may include some items when calculating a ratio, and few
may include others. Thus when it comes to a comparison of both
companies, it becomes difficult.
7. Ignorance of the Qualitative Aspect

Ratio analysis ignores the qualitative view of the firm and tends to include
only the monetary aspect.
8. Opportunities for Window Dressing

Some firms may manipulate the numbers to bring about changes to the
ratio for displaying a better picture of the firm. Thus in ratio analysis, there
are scopes of window dressing.
9. The Mix of Historical and Actual Numbers

Ratio analysis can be misleading at times because elements from profit and
loss statements are based on actual cost, whereas elements from the
balance sheet are based on historical. Thus, comparing elements as a mix of
both can be deceptive at times and may not give the desired result.
10. Time Effect

Some ratio pick numbers from the balance sheet, which is prepared only on
the accounting period’s last day. Thus if there is any sudden shoot or
decline in the number pertaining to the last day of the accounting period, it
can drastically impact the overall ratio analysis.
Conclusion
Ratio analysis has both advantages and disadvantages of its own and solely
depends on the analyst who is using this and what he/she is using this for.
Even then, the advantages clearly outweigh the disadvantages as for people
outside the company; this is the only way to get a better view of the
company and understand its financials. Ratio analysis plays a major role in
any kind of fundamental analysis specific to a company.
Framework for Ratio Analysis

Ratio analysis of financial statements is another tool that helps
identify changes in a company’s financial situation. A single ratio is
not sufficient to adequately judge the financial situation of the
company. Several ratios must be analyzed together and compared
with prior-year ratios, or even with other companies in the same
industry. This comparative aspect of the analysis is extremely
important in financial analysis. It is important to note that ratios are
parameters and not precise or absolute measurements. Thus, ratios
must be interpreted cautiously to avoid erroneous conclusions. An
analyst should attempt to get behind the numbers, place them in
their proper perspective, and, if necessary, ask the right questions
for further types of ratio analysis.
#1 – Vertical Analysis
What is Vertical Analysis?
Vertical analysis is a technique used to identify where a company
has applied its resources and in what proportions those resources
are distributed among the various balance sheets and income
statement accounts. The analysis determines the relative weight of
each account and its share in asset resources or revenue generation
Vertical Analysis – Income Statement

 On the income statement, vertical analysis is a universal tool
for measuring the firm’s relative performance from year to year in
terms of cost and profitability.
 It should always be included as part of any financial analysis.
Here, percentages are computed in relation to Sales, which are
considered to be 100%.
 This vertical analysis effort in the income statement is often
referred to as margin analysis since it yields different margins in
relation to sales.
 It also helps us do the time series analysis ( how the margins
have increased/decreased over the years) and also helps in cross-
sectional analysis with other comparable companies in the industry.
Colgate Case Study

 For each year, Income Statement line items are divided by
their respective year’s Top Line (Net Sales) number.
 For example, for Gross Profit, it is Gross Profit / Net Sales.
Likewise for other numbers
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What can we interpret with Vertical Analysis of Colgate?
 Vertical Ratio Analysis helps us with analyzing historical trends.

 Please note that from vertical analysis, we only get to the
point of asking the right questions (identification of
problems). However, we do not get answers to our questions here.
 In Colgate, we note that the gross profit margin (Gross
Profit / Net Sales) has been in the range of 59.4% to 60.8%. Why
almost constant?
 We also note that the Selling General and administrative
expenses (SG&A) have increased from 33.8.1% in 2016 to 36.5% in
the year ending 2020. Why?
 Also, note that the operating income dropped significantly in
2019. Why?
 Net income increased to less than 16.4%. Why?
 Also, effective tax rates are decreasing over the years (from
30.8% in 2016 to 21.6% in 2020). Why?
Vertical Analysis – Balance Sheet
 Vertical Analysis of the Balance Sheet normalizes the Balance
Sheet and expresses each item in the percentage of total
assets/liabilities.
 It helps us to understand how each item of the balance
sheet has moved over the years. For, eg. Did the debt increase or
decrease?
 It also helps in the cross-sectional analysis (comparing the
balance sheet strength with other comparable companies)
Colgate Case Study

 For each year, Balance Sheet line items are divided by their
respective year’s Top Assets (or Total Liabilities) number.
 For example, for Accounts Receivables, we calculate as
Receivables / Total Assets. Likewise for other balance sheet items
Interpretation of Colgate’s Vertical Analysis

 Cash and Cash equivalents decreased from 10.8% in 2016 and
currently stand at 5.6% of the total assets. Why is it reducing?
 Receivables decreased from 11.5% in 2016 to 7.9% in
2020. Does this mean stricter credit policy terms?
 What is included in “other current assets”? It remains stable
within 3.2% to 3.6% of the total assets.
 What is included in other assets? Why it is increasing?
 On the liabilities side, there can be many observations we can

highlight. Accounts payable decreased continuously over the few
years and currently stands at 8.8% of the total assets.
 Why Long Term Debt as a percentage of liabilities is
decreasing over the years. For this, we need to investigate this in
the 10K.
 Non controlling interests have remained in the range of 2.1%
to 2.9%
#2 – Horizontal Analysis
What is Horizontal Analysis?
Horizontal analysis is a technique used to evaluate trends over
time by computing percentage increases or decreases relative to a
base year. It provides an analytical link between accounts calculated
at different dates using the currency with different purchasing
powers. In effect, this analysis indexes the accounts and compares
the evolution of these over time.
As with the vertical analysis methodology, issues will surface that
need to be investigated and complemented with other financial
analysis techniques. The focus is to look for symptoms of problems
that can be diagnosed using additional techniques. Let’s look at an
example.
Colgate Case Study

We calculate the growth rate of each of the line items with respect
to the previous year.
For example, to find the growth rate of Net Sales of 2020, the
formula is (Net Sales 2020 – Net Sales 2019) / Net Sales 2019
What can we interpret with Horizontal Analysis of Colgate

Palmolive?
 In 2020, Colgate’s new sales growth increased by 5%. Why?

 The Cost of Sales growth, however, has decreased (positive
from the company’s point of view). Why is this so?
 Net Income growth increased in 2020. Why?
#3 – Trend Analysis
What is Trend Analysis?
Trend Analysis compares the overall growth of key financial statement line items
over the years from the base case.
Colgate Case Study

For example, in the case of Colgate, we assume that 2016 is the
base case and analyze the performance in Sales and Net profit over
the years.
 We note that Sales have increased by only 8.4% over a period

of 4 years (2016-2020).
 We also note that the overall net profit has increased by 10.4%
over the 4 year period.
Solvency Ratio Analysis
Solvency Ratio Analysis type is primarily sub-categorized into two
parts – Liquidity Analysis and Turnover Analysis of financial
statement. They are further sub-divided into 10 ratios, as seen in the
diagram below.
We will discuss each subcategory one by one.
Liquidity ratio analysis measure how liquid the company’s assets are

(how easily can the assets be converted into cash) as compared to
its current liabilities. There are three common liquidity ratio
 Current analysis
 Acid test (or quick asset) ratio
 Cash Ratio
#4 – Current Ratio
What is the Current Ratio?
The current ratio is the most frequently used ratio to measure the
company’s liquidity as it is a quick, intuitive, and easy measure to
understand the relationship between the current assets and current
liabilities. It basically answers this question “How many dollars in
current assets does the company have to cover each $ of
current liabilities.”
Formula
Current Ratio Formula = Current Assets / Current Liabilities
Example
Let us take a simple Current Ratio Calculation example,
 Current Assets = $200 Current Liabilities = $100

 Current Ratio = $200 / $100 = 2.0x
This implies that the company has two dollars of current assets for
every one dollar of current liabilities.
Analyst Interpretation
 The current ratio provides us with a rough estimate of whether
the company would be able to “survive” for one year or not. If
Current Assets are greater than Current Liabilities, we interpret that
the company can liquidate its current assets and pay off its current
liabilities and survive at least for one operating cycle.
 The current Ratio in itself does not provide us with full details
of the quality of current assets and whether they are fully realizable.
 If the current assets consist primarily of receivables, we should
investigate the collectability of such receivables.
 If current assets consist of large Inventories, then we should be
mindful of the fact that inventories will take longer to convert into
cash as they cannot be readily sold. Inventories are much less liquid
assets than receivables.
 The average maturities of current assets and current liabilities
should also be looked into. If current liabilities mature in the next
one month, then-current assets providing liquidity in 180 days may
not be of much use.
Colgate Case Study

Let us now calculate the Current Ratios for Colgate.
 Colgate’s current ratio has deteriorated over the past 5 years.

Its current ratio of 2020 was at 0.99x
 This implies that Colgate’s current assets are almost equal to
its current liabilities.
 We will still need to investigate the quality and liquidity of
Current Assets. We note that around 45% of current assets in 2020
consists of Inventories and Other Current Assets. This may affect the
liquidity position of Colgate.
 When investigating Colgate’s inventory, we note that the
majority of the Inventory consists of Finished Goods (which is better
in liquidity than raw materials supplies and work-in-progress).
source: Colgate 2020 10K Report, Pg – 125
#5 – Quick Ratio Analysis

What is a Quick Ratio?
Sometimes current assets may contain huge amounts of
inventory, prepaid expenses, etc. This may skew the current ratio
interpretations as these are not very liquid. To address this issue, if
we consider the only most liquid assets like Cash and Cash
equivalents and Receivables, then it should provide us with a better
picture of the coverage of short-term obligations. This ratio is
known as the Quick Ratio or the Acid Test.
The rule of thumb for a healthy acid test index is 1.0.
Formula
Quick Ratio Formula = (Cash and Cash Equivalents + Accounts
Receivables)/Current Liabilities
Example
Let us take a simple Quick Ratio Calculation example,
 Cash and Cash Equivalents = $100

 Accounts Receivables = $500
 Current Liabilities = $1000
Then Quick Ratio = ($100 + $500) / $1000 = 0.6x
 Accounts Receivables are more liquid than inventories.
 This is because Receivables directly convert into cash after the
credit period; however, Inventories are first converted
to Receivables, which in turn take further time to convert into cash.
 In addition, there can be uncertainty related to the true value
of the inventory realized as some of it may become obsolete, prices
may change, or it may become damaged.
 It should be noted that a low quick ratio may not always mean
liquidity issues for the company. You may find low quick ratios in
businesses that sell on a cash basis (for example, restaurants,
supermarkets, etc.). In these businesses, there are no receivables;
however, there may be a huge pile of inventory.
Colgate Case Study

Let us now look at the Quick Ratio Interpretation in Colgate.
The Quick Ratio of Colgate is also decreasing (similar to the current

ratio). This acid test shows us the company’s ability to pay off short-
term liabilities using Receivables and Cash & Cash Equivalents.
#6 – Cash Ratio analysis

What is the Cash Ratio?
The Cash Coverage ratio considers only the Cash and Cash
Equivalents (there are the most liquid assets within the Current
Assets). If the company has a higher cash ratio, it is more likely to be
able to pay its short-term liabilities.
Formula
Cash Ratio Formula = Cash & Cash equivalents / Current Liabilities
Example
Let us take a simple Cash Ratio Calculation example,
 Cash and Cash Equivalents = $500

 Current Liabilities = $1000
Then Quick Ratio = $500 / $1000 = 0.5x
 All three ratios – Current Ratios, Quick Ratios, and Cash Ratios
should be looked at for understanding the complete picture of the
Company’s liquidity position.
 The cash Ratio is the ultimate liquidity test. If this number is
large, we can obviously assume that the company has enough cash
in its bank to pay off its short-term liabilities.
Colgate Case Study

Let us calculate Cash Ratios in Colgate.
Colgate’s cash ratio has decreased from 0.45x in 2017 to 0.20x in

2020.
Turnover Ratios
We saw from the above three liquidity ratios (Current, Quick, and
Cash Ratios) that it answers the question, “Whether the company
has enough liquid assets to square off its current liabilities.” So this
ratio is all about the $ amounts.
However, when we look at Turnover ratio analysis, we try to analyze

the liquidity from “how long it will take for the firm to convert
inventory and receivables into cash or time is taken to pay its
suppliers.”
The commonly used turnover ratios include:
 Receivables turnover
 Accounts receivables days
 Inventory turnover
 Inventory days
 Payables turnover
 Payable days
 Cash Conversion Cycle
#7 – Receivables Turnover Ratio

analysis
What is Receivables Turnover Ratio analysis?
Accounts Receivables Turnover Ratio can be calculated by dividing
Credit Sales by Accounts Receivables. Intuitively. It provides us the
number of times Accounts Receivables (Credit Sales) is converted
into Cash Sales
Formula
Receivables Turnover Formula = Credit Sales / Accounts
Receivables
Accounts Receivables can be calculated for the full year or for a

specific quarter. For calculating accounts receivables for a quarter,
one should take annualized sales in the numerator.
Example
Let us take a simple Receivables Turnover Calculation example,
 Sales = $1000
 Credit given is 80%
 Accounts Receivables = $200
 Credit Sales = 80% of $1000 = $800
Accounts Receivables Turnover = $800 / $200 = 4.0x
 Please note that Total Sales include Cash Sales + Credit Sales.
Only Credit Sales convert to Accounts Receivables; hence, we
should only take Credit Sales.
 If a company sells most of its items on a Cash Basis, then there
will be No Credit Sales.
 Credit Sales figures may not be directly available in the annual
report. You may have to dig into the Management discussion and
analysis to understand this number.
 If it is still hard to find the percentage of credit sales, then do
have a look at conference calls where analysts question the
management on relevant business variables. Sometimes it is not
available at all.
Colgate Case Study

 To calculate the receivables turnover, we have considered the
average receivables. We consider the “average” figures as these are
balance sheet items.
 For, e.g., as shown in the image below, we took the average
receivables of 2019 and 2020.
 Also, please note that I have taken the assumption that 100%
of Colgate’s Sales were “Credit Sales.”
 We note that the Receivables Turnover was above 10x in 2016-

2020. In 2020, it was at 12.18x
 Higher Receivables Turnover implies a higher frequency of
converting receivables into cash (this is good!)
#8 – Days Receivables
What are Days Receivables?
Days receivables are directly linked with the Accounts Receivables
Turnover. Days receivables express the same information but in
terms of the number of days in a year. This provides an intuitive
measure of Receivables Collection Days.
Formula
Accounts Receivables Days Formula = Number of Days in Year /
Accounts Receivables Turnover
You may calculate Account Receivable days based on the year-end

balance sheet numbers.
Many analysts, however, prefer to use the average balance sheet
receivables number to calculate the average collection period. (a
right way is to use the average balance sheet)
Let us take the previous example and find out the Days Receivables.
Example
Let us take a simple Days Receivables Calculation example,
 Accounts Receivables Turnover = 4.0x

 Number of days in a year = 365
Days Receivables = 365 / 4.0x = 91.25 days ~ 91 days
This implies that it takes 91 days for the company to convert

Receivables into Cash.
 The number of days taken by most analysts is 365; however,
some analysts also use 360 as the number of days in the year. This is
normally done to simplify the calculations.
 Accounts receivable days should be compared with the
average credit period offered by the company. For example, in the
above case, if the Credit Period offered by the company is 120 days
and they are receiving cash in just 91 days, this implies that the
company is doing well to collect its receivables.
 However, if the credit period offered is said 60 days, then you
may find a significant amount of previous accounts receivables on
the balance sheet, which obviously is not good from the company’s
point of view.
Colgate Case Study

 Let’s calculate Days Receivables for Colgate. To calculate Days
Receivables, we have taken 365 days’ assumption.
 Since we had already calculated the receivables turnover
above, we can easily calculate the day’s receivables now.
Days receivables or Average Receivables collection days have
decreased from around 34.1 days in 2017 to 30 days in 2020.
 This means that Colgate is doing a better job of collecting its

receivables. They may have started implementing a stricter credit
policy.
#9 – Inventory Turnover Ratio

analysis
What is Inventory Turnover Ratio analysis?
The Inventory Ratio means how many times the inventories are
restored during the year. It can be calculated by taking the Cost of
Goods Sold and dividing it by Inventory.
Formula
Inventory Turnover Formula = Cost of Goods Sold / Inventory.
Let us take a simple Inventory Turnover Ratio Calculation example.
 Cost of Goods Sold = $500

 Inventory = $100
Inventory Turnover Ratio = $500 / $100 = 5.0x
This implies that during the year, inventory is used up 5 times and is
restored to its original levels.
You may note that when we calculate receivables turnover, we
took Sales (Credit Sales); however, in inventory turnover ratio, we
took Cost of Goods Sold. Why?
The reason is that when we think about receivables, it directly

comes from Sales made on a credit basis. However, the Cost of
Goods sold is directly related to inventory and is carried on the
balance sheet at cost.
To get an intuitive understanding of this, you may see the BASE

equation.
B+A=S+E
 B = Beginning Inventory
 A = Addition to Inventory (purchases during the year)
 S = Cost of Goods sold
 E = Ending Inventory
S = B + A – E
As we note from the above equation, Inventory is directly related to

the Cost of Goods Sold.
Colgate Case Study

 Let us calculate the Inventory Turnover Ratio of Colgate. Like
in receivables turnover, we take the average inventory for
calculating Inventory Turnover.
 Colgate’s inventory consists of Raw material and supplies,
work in progress, and finished goods.
 Colgate’s inventory turnover has been decreasing over the last

4 years (In 2020, it was at 4.20x)
 A lower inventory turnover ratio means that Colgate is taking
longer to process its inventory to finished goods.
#10 – Days Inventory

What is the Days Inventory?
Think of Inventory Days as the approximate number of days it takes
for inventory to convert into a finished product.
Formula
Inventory Days Formula = Number of days in a year / Inventory
Turnover.
Example
Let us take a simple Days Inventory Calculation example. We will
use the previous example of the Inventory Turnover Ratio and
calculate Inventory Days.

 Inventory = $100
 Inventory Turnover Ratio = $500 / $100 = 5.0x
Inventory Days = 365/5 = 73 days.
This implies that Inventory is used up every 73 days on average and

is restored to its original levels.
 You may also think of inventory days as the number of days a
company can continue with production without replenishing its
inventory.
 One should also look at the seasonality pattern in how
inventory is consumed, depending on the demand. It is rare that
inventory is consumed constantly throughout the year.
Colgate Case Study

Let us calculate the Inventory turnover days for Colgate. Inventory
Days for Colgate = 365 / Inventory Turnover.
 We see that the inventory processing period has increased

from 70.7 days in 2017 to around 86.9 days in 2020.
 This implies that Colgate is processing its inventory slowly as
compared to 2017.
#11 – Accounts Payable

Turnover
What is Accounts Payable Turnover?
Payables turnover indicates the number of times that payables are
rotated during the period. It is best measured against purchases
since purchases generate accounts payable.
Formula
Payables Turnover Formula = Purchases / Accounts Payables
Example
Let us take a simple Accounts Payable Turnover calculation
example. From the Balance Sheet, you are provided with the
following –
 Ending Inventory = $500

 Beginning Inventory = $200
 Accounts Payable = $200
In this example, we need to first find out Purchases during the year.
If you remember the BASE equation that we used earlier, we can
easily find purchases.
B+A=S+E
 B = Beginning Inventory
 A = Additions or Purchases during the year
 S = COGS
 E = Ending Inventory
we get, A = S + E – B
Purchases or A = $500 + $500 – $200 = $800
Payables Turnover = $800 / $200 = 4.0x
 Some analysts make the mistake of taking the Cost of Goods
Sold in the numerator of this accounts payable turnover formula.
 It is important to note here that Purchase is the one that leads
to Payables.
 We earlier saw Sales can be Cash Sales and Credit sales.
Likewise, Purchases can be Cash Purchases as well as Credit
Purchases. Cash Purchases do not result in payables; it is only the
Credit Purchases that lead to Accounts payables.
 Ideally, we should seek Credit Purchase information from
the annual report.
Colgate Case Study

Here, we first calculate the Purchases.
Purchases 2020 = COGS 2020 + Inventory 2020 – Inventory 2019
We note that the Payable turnover decreased to 5.12x in 2020. This
implies that Colgate is taking a bit longer to make payments to its
suppliers.
Once we have the purchases, we can now find the payables

turnover. Please note that we use the average accounts payable to
calculate the ratio.
#12 – Days Payable Ratio

Analysis
What is Days Payable Ratio analysis?
Payable days represent the average number of days a company
takes to make the payment to its suppliers.
Formula
Payables Days Formula = Number of Days in a year / Payables
Turnover
Example
Let’s take a simple Payable Days calculation example. We will use
the previous example of Accounts Payable Turnover to find the
Payable days.
 We earlier calculated Accounts Payable Turnover as 4.0x

 Payable Days = 365 / 4 = 91.25 ~ 91 days
This implies that the company pays its clients every 91 days.
 The higher the accounts payable days, the better it is for the
company from a liquidity point of view.
 Payable days can be affected by seasonality in the business.
Sometimes a business may stock inventories due to the upcoming
business cycle. This may distort the interpretations that we make on
payable days if we are not aware of seasonality.
Colgate Case Study

Let us calculate Accounts Payable for Colgate. Since we have
already calculated the Payables Turnover, we can calculate Payable
days = 365/Payables Turnover.
Payable days have increased to 71.4 days in 2020 as compared to

68.5 days in 2017.
#13 – Cash Conversion Cycle

What is the Cash Conversion Cycle?
The cash conversion cycle is the total time taken by the firm to
convert its cash outflows into cash inflows (returns). Think of Cash
Conversion Cycle is a time taken by a company to purchase the raw
materials, then convert inventory into the finished product and sell
the product and receive cash and then make the necessary payout
for the purchases.
The Cash Conversion cycle depends primarily on three variables –

Receivable Days, Inventory Days, and Payable Days.
Formula
Cash Conversion Cycle Formula = Receivable Days + Inventory
Days – Payable Days
Example
Let us take a simple Cash Conversion Cycle calculation example,
 Receivable Days = 100 days

 Inventory Days = 60 days
 Payable Days = 30 days
Cash conversion cycle = 100 + 60 – 30 = 130 days.
 It signifies the number of days the firm’s cash is stuck in the
operations of the business.
 A higher cash conversion cycle means that it takes a longer
time for the firm to generate cash returns.
 However, a lower cash conversion cycle may be viewed as a
healthy company.
 Also, one should compare the cash conversion cycle with the
industry averages so that we are in a better position to comment on
the higher/lower side of the cash conversion cycle.
Colgate Case Study

Cash Conversion Cycle of Colgate = Receivable Days + Inventory
Days – Payable Days
 Overall, we note that the cash collection cycle has increased

from around 36.35 days in 2017 to 45.51 days in 2020.
 This implies that overall, the Colgate cash conversion cycle is
deteriorating each year.
 We note that the receivables collection period has decreased
overall, which has contributed to the decrease in the cash
conversion cycle.
 Additionally, we also note that the average payable days have
increased, which again positively contributed to the cash conversion
cycle.
 However, the increase in inventory processing days in recent
years has negatively affected its cash conversion cycle.
Ratio Analysis – Operating

Performance
Operating performance ratios try and measure how the business is
performing at the ground level and is sufficiency, generating returns
relative to the assets deployed.
Operating Performance Ratios are two sub-divided as per the

diagram below
Operating Efficiency Ratios

#14 – Asset Turnover Ratio
analysis
What is Asset Turnover Ratio analysis?
The asset turnover ratio is a comparison of sales to total assets.
This ratio provides an indication of how efficiently the assets are
being utilized to generate sales.
Formula
Asset Turnover ratio Formula = Total Sales / Assets
Example
Let us take a simple Cash Conversion Cycle calculation
example.
 Sales of Company A = $900 million

 Total Assets = $1.8 billion
Asset Turnover = $900/$1800 = 0.5x
This implies that for every $1 of assets, the company is generating

$0.5
 Asset turnovers can be extremely low or very high, depending
on the Industry they operate in.
 The asset turnover of the Manufacturing firm will be on the
lower side due to a large asset base as compared to a company that
operates in the services sector (lower assets).
 If the firm has seen considerable growth in assets during the
year or the growth has been seasonal, then the analyst should find
additional information to interpret such numbers.
Colgate Case Study

Asset Turnover of Colgate = Sales / Average Assets
We note that the Asset Turnover for Colgate is showing a declining
trend. Asset turnover was at 1.06x in 2020;
#15 – Net Fixed Asset Turnover

What is Net Fixed Asset Turnover?
Net Fixed Asset turnover reflects the utilization of fixed assets
(Property Plant and Equipment).
Formula
Net Fixed Asset Turnover Formula = Total Sales / Net Fixed Assets
Example
Let us take a simple Net Fixed Asset Turnover calculation example.
 Total Sales = $600

 Net Fixed Assets = $600
Net Fixed Asset Turnover = $600 / $600 = 1.0x

This implies that for every $ spent on the fixed assets, the company
is able to generate $1.0 in revenues.
 This ratio should be applied to high capital intensive
sectors like Automobile, Manufacturing, Metals, etc.
 You should not apply this ratio to asset-light companies like
Services or Internet-based as the Net Fixed assets will be really low
and not meaningful from an analysis point of view.
 This number can look temporarily bad if the firm has recently
added greatly to its capacity in anticipation of future sales.
Colgate Case Study

Net Fixed Asset Turnover of Colgate = Sales / Average Net Fixed
Assets (PPE, net)
Unlike Asset Turnover, Net Fixed asset turnover is also showing an
increasing trend.
Net Fixed Asset turnover was at 3.91 in 2017; however, this ratio has
increased to 4.41x in 2020.
#16 – Equity Turnover

What is Equity Turnover?
Equity turnover is the ratio of Total Revenue to the Shareholder’s
Equity Capital. This ratio measures how efficient the company is
deploying equity to generate sales.
Formula
Equity Turnover Ratio Formula = Total Sales / Shareholder’s Equity
Example
Let us take a simple Equity Turnover calculation example,
 Total Sales = $600

 Shareholder’s Equity = $300
Equity Turnover Ratio = $600 / $300 = 2.0x.

This implies that the company is generating $2.0 of sales for every
$1.0 of shareholder’s equity.
Colgate Case Study

Colgate Equity Turnover = Sales / average Shareholder’s Equity
We note that historically, Colgate’s Equity Turnover is negative or

very high. We cannot conclude much from here.
This was primarily due to two reasons – a) Share buyback program
of Colgate resulting in lowering of the Equity base each year. b)
Accumulated losses net of taxes (these are those losses that don’t
flow into the income statement).
Operating Profitability Ratio
Analysis
Operating Profitability Ratios measure how much the costs are
relative to the sales and how much profit is generated in the overall
business. We try to answer questions like “how much the profit
percentage” or “Is the firm controlling its expenses by buying
inventory etc. at a reasonable price?”
#17 – Gross Profit Margin

What is the Gross Profit Margin?
Gross Profit is the difference between sales and the direct cost of
making a product or providing service. Please note that costs like
overheads, taxes, interests are not deducted here.
Formula
Gross Margin Formula = (Sales – Costs of Goods Sold)/Sales =
Gross Profit / Sales
Example
Let us take a simple Gross Margin calculation example,
Assume from the Sales of a firm is $1,000 and its COGS is $600
 Gross Profit = $1000 – $600 = $400

 Gross Profit Margin = $400/$1000 = 40%
 Gross Margin can vary drastically between industries. For
example, digital products sold online will have an extremely high
Gross Margin as compared to a company that sells laptops.
 Gross margin is extremely useful when we look at the
historical trends in the margins. If the Gross Margins has increased
historically, then it could be either because of the price increase or
control of direct costs. However, if the Gross margins show a
declining trend, then it may be because of increased
competitiveness and therefore resulting in the decreased sales
price.
 In some companies, Depreciation expenses are also included
in Direct Costs. This is incorrect and should be shown below the
Gross Profit in the Income Statement.
Colgate Case Study

Let us calculate Colgate’s Gross Margin. Colgate’s Gross Margin =
Gross Profit / Net Sales.
Please note that depreciation related to manufacturing operations
are included herein Cost of Sales (Colgate 10K 2020, pg 79)
Shipping and handling costs may be reported either in the Cost of
Sales or Selling General and Admin Expenses. Colgate has, however,
reported these costs as a part of Selling General and Admin
Expenses. If such expenses are included in the Cost of Sales, then
the Gross margin of Colgate would have decreased by 845 bps and
decreased by 810 bps in both 2019 and 2018, respectively.
source: – Colgate 10K 2020, pg 54
#18 – Operating Profit Margin

What is the Operating Profit Margin?
Operating profit or Earnings Before Interest and Taxes (EBIT)
margin measures the rate of profit on sales after operating
expenses. Operating income can be thought of as the “bottom line”
from operations.
Formula
Operating Profit Margin = EBIT / Sales
Example
Let us take a simple Operating Profit Margin calculation example,
We will use the previous example.
 Assume from the Sales of a firm is $1,000 and its COGS is $600
 SG&A expense = $100
 Depreciation and Amortization = $50
 EBIT = Gross Profit – SG&A – D&A = $400 – $100 – $50 =
$250
EBIT Margin = $250/$1000 = 25%
 Please note that some analyst takes EBITDA (Earning before
interest taxes depreciation and amortization) instead of EBIT as
Operating Profit. If this is so, they assume that depreciation and
amortization are non-operating expenses.
 The most analyst prefers taking EBIT as Operating Profit.
Operating Profit Margin is most commonly tracked by analysts.
 You need to be mindful of the fact that many companies
include non-recurring items (gains/losses) in SG&A or
other expenses above EBIT. This may increase or decrease the EBIT
Margins and skew your historical analysis.
Colgate Case Study

Colgate’s Operating Profit = EBIT / Net Sales.
Historically, Colgate’s Operating Profit has remained in the range of

24-26.0%
However, in 2019, Colgate’s EBIT Margin decreased significantly to
22.6%. In 2019, Operating profit included charges resulting from the
restructuring expenses (Global Growth and Efficiency Program),
acquisition-related costs and a benefit related to a value-added tax
matter in Brazil
#19 – Net Margin
What is Net Margin?
Net Margin is basically the net effect of operating as well as
financing decisions taken by the company. It is called a Net Margin
because, in the numerator, we have Net Income (Net of all
the operating expenses, interest expenses as well as taxes)
Formula
Net Margin Formula = Net Income / Sales
Example
Let us take a simple Net Margin calculation example;
continuing with our previous example, EBIT = $250, Sales = $1000.
 We now assume that interest is $100, and taxes is charged at

the rate of 30% of EBIT = $250
 Interest = $100
 EBT = $150
 Taxes = $45
 Net Profit = $105
Net Profit Margin = $105/$1000 = 10.5%
 Like Gross margins, Net Margins can also vary drastically
across industries. For example, Retail is a very low margin business
(~5%), whereas a website selling digital products may have a Net
Profit Margin in excess of 40%.
 Net Margins is useful for comparison between companies
within the same industry due to similar products and cost
structure.
 Net Profit Margins can vary historically due to the presence of
non-recurring items or non-operating items.
Colgate Case Study

Let us have a look at the Net Margin of Colgate.
 Historically, Net Margin for Colgate has been in the range of

13.1% – 16.4%.
 However, Net Margin increased in 2020 to 16.4% primarily due
to aftertax benefits of $13 million resulting from the restructuring
program (Global Growth and Efficiency Program) and $71 million
tax benefit related to
subsidiary and operating structure initiatives.
#20 – Return on Total Assets

What is Return on Total Assets?
Return on Assets or Return on Total Assets relates to the firm’s
earnings to all capital invested in the business.
Formula
Return on Total Asset Formula = EBIT / Total Assets.
Two important things to note there –
 Please note that in the denominator, we have Total Assets,

which basically takes care of both the Debt and Equity Holders.
 Likewise, in the numerator, the Earnings should reflect
something that is before the payment of interest.
Example
Let us take a simple Return on Total example,
 Company A has an EBIT of $500 and Total Assets = $2000

 Return on Total Assets = $500/$2000 = 25%
This implies that the company is generating a Return on Total

Assets of 25%.
 Many analysts use the numerator as Net Income + Interest
Expenses instead of EBIT. They basically are deducting the taxes.
 Return on Assets can be low or high, depending on the type of
industry. If the company operates in a capital-intensive sector (Asset
heavy), then the return on assets may be on the lower side.
However, if the company is Asset Light (services or internet
company), they tend to have had a higher Return on Assets.
Colgate Case Study

Let us now calculate the Return on the total Assets of Colgate.
Colgate’s Return On Total Assets = EBIT / Average total assets
Colgate’s Return on total assets has been declining since 2017.

Most recently, it has declined to its lowest at 25.1%. Why?
Let’s investigate.
 Two reasons can contribute to decreasing – either the

denominator, i.e., average assets have increased significantly, or the
Numerator Net Sales have dropped significantly.
 In Colgate’s case, the total assets increased significantly to
$15.03 billion in 2019 and $15.92 billion in 2020. We also note that
the overall Net sales have increased by 5% in 2020. The net effect of
the two has resulted in a decrease in the decline in Return on Total
Assets.
#21 – Return on Equity

What is Return on Equity?
Return on Equity means the rate of return earned on the Total
Equity of the firm. It can be thought of as dollar profits a company
generates on each dollar investment of Total Equity.
Formula
Return on Equity Formula = Net Income / Total Equity
Please note Total Equity = Ordinary Capital + Reserves +

Preference + Minority Interests
Example
Let us take a simple Return on Equity example.
 Net Income = $50

 Total Equity = $500
Return Equity = $50/$500 = 10%
 Please note that the Net income will be before the preference
dividends and minority interest are paid.
 Higher Return on Equity implies a higher return to the
Stakeholders.
Colgate Case Study

 Colgate’s Return on Equity = Net Income (before pref
dividends & minority interest) / average total equity.
 Please do remember to take the Net income before minority
interest payments in Colgate. This is because we are using the total
equity (including the non-controlling assets).
 We note the Return on Equity in 2020 was at 344.8%. This
result is somehow not making much sense here and cannot be
interpreted.
 Return on Equity jumped primarily due to a decrease in the
denominator – Shareholder’s equity (increase in treasury
stock because of buyback and also because of accumulated losses
that flow through the Shareholder’s Equity)
#22 – Return on Owner’s Equity

What is Return on Owners Equity?
Return on equity or Return on Owner’s Equity is based only on the
common shareholder’s equity. Preferred dividends and minority
interests are deducted from Net Income as they are a priority claim.
Return on equity provides us with the Rate of return earned on the
Common Shareholder’s Equity.
Formula
Return on Owners Equity = Net Income (after pref dividends and
minority interest) / Common Shareholder’s Equity
Example
Let us take a simple ROE calculation example,

 Total Equity = $500
 Owners Equity = $400
ROE (owners) = $50 / $400 = 12.5%
 Since common shareholder’s equity is a year-end number,
some analyst prefer taking the average shareholder’s equity
(average of beginning and year-end)
 ROE can be basically considered as a profitability ratio from a
shareholder’s point of view. This provides how much returns on
generated from shareholder’s investments, not from the overall
company investments in assets. (Please note Total Investments =
Shareholder’s Equity + Liability that includes Current Liabilities
and Long term Liabilities)
 ROE should be analyzed over a period of time (5 to 10 year
period) in order to get a better picture of the growth of the
company. Higher ROE does not get passed directly to the
shareholders. Higher ROE -> Higher Stock Prices.
Colgate Case Study

Like the Return on Total Equity, Return on Owners Equity has
jumped significantly to 626.7% in 2020.
Return on Equity increased because of the very low Shareholder’s
Equity base in 2019-2020. (reasons as discussed earlier in Return on
Total Equity).
#23 – Dupont ROE

What is Dupont ROE?
Dupont ROE is nothing but an extended way of writing an ROE
formula. It divides ROE into several ratios that collectively equal ROE
while individually providing insight to the most important term in
ratio analysis of a financial statement.
Formula
Dupont ROE formula
= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets /
Shareholder’s Equity)
The above formula is nothing but the ROE formula = Net Income /
Shareholder’s Equity.
Example
Let us take a simple Dupont ROE calculation example.

 Sales = $500
 Total Assets = $200
 Gross Margin = Net Income / Sales = $50 / $500 = 10%
 Asset Turnover = Sales / Total Assets = $500/$200 = 2.5x
 Asset Leverage = Total Asset / Shareholder’s Equity = $200 /
$400 = 0.5
Dupont ROE = 10% x 2.5 x 0.5 = 12.5%
 THE Dupont ROE formula provides additional ways to analyze
the ROE ratio and helps us find out a reason for the final number.
 The first term (Net Income/Sales) is nothing but the Net Profit
Margin. We know that the Retail sector operates on a low-profit
margin; however, software product-based companies may
operating on a high-profit margin.
 The second term here is (Sales/Total Assets); we normally call
this term Asset turnovers. It provides us with a measure of how
efficiently the assets are being utilized.
 The third term here is (Total Assets / Shareholder’s Equity); we
call this ratio Asset Leverage. Asset leverage gives insight into how
the company may be able to finance the purchase of new assets.
Higher Asset leverage does not mean that it is better than the low
multiplier. We need to look at the financial health of the company
by performing a full ratio analysis of the financial statement.
Colgate Case Study
Colgate Dupont ROE = (Net Income / Sales) x (Sales / Total Assets) x
(Total Assets / Shareholder’s Equity)
Please note that the Net Income is after the minority shareholder’s
payment.
Also, the shareholder’s equity consists of only the common
shareholders of Colgate.
We note that the asset turnover has shown a declining trend over
the past 7-8 years.
Profitability, however, has increased over the past 4 years.
Asset leverage (average total assets / average total equity) is also

decreasing over the years. You may note that the Asset Leverage
has shown a steady decline over the past 4 years and is currently
standing at 18.65x.
The net result due to the three above factors resulted in a decrease
in ROE.
Risk Analysis
Risk analysis examines the uncertainty of income for the firm and
for an investor.
Total firm risks can be decomposed into three basic sources – 1)
Business risk, 2) Financial Risk 3) External Liquidity Risk
Business Risk
Wikipedia defines it as “the possibility a company will have lower
than anticipated profits or experience a loss rather than making a
profit.” If you look at the income statement, there are many line
items that contribute to the risk of making losses. In this context, we
discuss three kinds of business risks – Total Leverage, Operating
Leverage, and Financial Leverage.
# 24 – Operating Leverage
What is Operating Leverage?
Operating leverage is the percentage change in operating profit
relative to sales. Operating leverage is a measure of how sensitive
the operating income is to the change in revenues.
Formula
Operating Leverage Formula = % change in EBIT / % change in
Sales.
Please note that the greater use of fixed costs, the greater the
impact of a change in sales on the operating income of a company.
Example
Let us take a simple Operating Leverage calculation example.
 Sales 2020 = $500, EBIT 2020 = $200

 Sales 2019 = $400, EBIT 2019 = $150
 % change in EBIT = ($200-$150)/$100 = 50%
 % change in Sales = ($500-$400)/$400 = 25%
Operating Leverage = 50/25 = 2.0x
This means that when Operating profit changes by 2% for every 1%

change in Sales.
 The greater the fixed costs, the higher is the operating
leverage.
 Between three to ten years of data should be used for
calculating Operating Leverages.
Colgate Case Study

 Colgate’s Operating Leverage = % change in EBIT / % change
in Sales
 I have calculated the operating leverages for each year from
2017 – 2020.
 Colgate’s operating leverage is very volatile as it ranges from
-3.95x to 1.88x. This is primarily due to the inclusion of restructuring
expenses in SG&A.
 It is expected that Colgate’s Operating leverage to be higher
as we note that Colgate has made significant investments
in intangible assets in 2019 and 2020.
# 25. Financial Leverage

What is Financial Leverage?
Financial leverage is the percentage change in Net profit relative to
Operating Profit. Financial leverage measures how sensitive the Net
Income is to the change in Operating Income.
Financial leverage primarily originates from the company’s financing

decisions (usage of debt). Like in the operating leverage, fixed
assets lead to higher operating leverage. In Financial leverage, the
usage of debt primarily increases the financial risk as they need to
pay off interest
Formula
Financial Leverage formula = % change in Net Income / % change
in EBIT
Example
Let us take a simple Financial Leverage calculation example,
 Net Income 2020 = $120, EBIT 2020 = $200

 Net Income 2019 = $40, EBIT 2019 = $150
 % change in EBIT = ($200-$150)/$100 = 50%
 % change in Net Income = ($120-$40)/$40 = 200%
Financial Leverage = 200/50 = 4.0x
This means that Net Income changes by 4% for every 1% change in

Operating Profit.
 The greater the Debt, the higher is the financial leverage.
 Between five to ten years of data should be used for
calculating Financial Leverages.
Colgate Case Study

Colgate’s Financial Leverage has remained volatile (-52.97x in 2018
and 1.49x in 2020)
# 26. Total Leverage

What is Total Leverage?
Total leverage is the percentage change in Net profit relative to its
Sales. Total leverage measures how sensitive the Net Income is to
the change in Sales.
Formula
Total Leverage Formula = % change in Net Profit / % change in
Sales
= Operating Leverage x Financial Leverage
Example
Let us take a simple Total Leverage calculation example,
 Sales 2020 = $500, EBIT 2020 = $200, Net Income 2020 = $120
 Sales 2019 = $400, EBIT 2019 = $150, Net Income 2019 = $40
 % change in Sales = ($500-$400)/$400 = 25%
 % change in EBIT = ($200-$150)/$100 = 50%
 % change in Net Income = ($120-$40)/$40 = 200%
Total Leverage = % change in Net Income / % change in Sales

=200/25 = 8x.
Total Leverage = Operating Leverage x Financial Leverage = 2 x 4 =

8x (Operating and Financial Leverage calculated earlier)
This implies for every 1% change in Sales, the Net Profit moves by
8%.
Higher sensitivity could be because of higher operating leverage
(higher fixed cost) and higher financial leverage (higher debt), 3-10
years of data should be taken to calculate the total leverage.
Colgate Case Study

Let us now look at the Total Leverage of Colgate.
 Colgate’s Total Leverage is also volatile (as there is significant

volatility in operating and financial leverage)
Financial Risk
Financial risk is the type of risk primarily associated with the risk of
default on the company loan. We discuss 3 types of financial risk
ratios – Leverage Ratio, Interest Coverage Ratio, and DSCR ratio.
# – 27. Leverage Ratio or Debt to

Equity Ratio
What is Leverage Ratio?
The leverage ratio calculates how much the company uses debt as
compared to its equity. This is an important ratio for bankers as it
provides the company’s ability to pay off debt using its own capital.
Formula
Leverage Ratio Formula = Total Debt (current + long term) /
Shareholder’s Equity
Generally, the lower the ratio better it is. Debt includes current debt
+ long-term debt.
Example
Let us take a simple Leverage Ratio calculation example.
 Current Debt = $100

 Long Term Debt= $900
Leverage Ratio = ($100 + $900) / $500 = 2.0x
 A lower ratio is generally considered better as it shows
greater asset coverage of liabilities with its own capital.
 Capital-intensive sectors generally show a higher debt to
equity ratio (leverage ratio) as compared to the services sector.
 If the leverage ratio is increasing over time, then it may be
concluded that the firm is unable to generate sufficient cash flows
from its core operations and is relying on external debt to stay
afloat.
Colgate Case Study

Leverage Ratio of Colgate = (Current portion of long term debt +
Long term Debt) / Shareholder’s Equity.
The Debt to Equity has decreased from 32.31x in 2018 to 6.90x in

2020. This is primarily due to an increase in shareholder’s equity
over the last 3 years. We note that the Debt Ratio in 2020 was 0.87.
# 28. Interest Coverage Ratio

What Is the Interest Coverage Ratio?
The Interest Coverage ratio signifies the ability of the firm to pay
interest on the assumed debt.
Formula
Interest Coverage Formula = EBITDA / Interest Expense
Please note that EBITDA = EBIT + Depreciation & Amortization
Example
Let us take a simple Interest Coverage Ratio calculation example,
 EBIT = $500
 Depreciation and Amortization = $100
 Interest Expense = $50
 EBITDA = $500 + $100 = $600
Interest Coverage Ratio = $600 / $50 = 12.0x
 Capital intensive firms have higher depreciation and
amortization, resulting in lower operating profit (EBIT)
 In such cases, EBITDA is one of the most important measures
as it is the amount available to pay off interest (depreciation and
amortization is a non-cash expense).
 Higher interest coverage ratios imply a greater ability of the
firm to payoff its interests.
 If Interest coverage is less than 1, then EBITDA is not sufficient
to pay off interest, which implies finding other ways to arrange
funds.
Colgate Case Study

Colgate’s Interest Coverage Ratio = EBITDA / Interest Expense.
Please note that depreciation and amortization expenses are not
provided in the income statement. These were taken from the Cash
Flow statements.
Also, the Interest expense shown in the Income Statement is the
net number (Interest Expense – Interest Income)
Colgate has a very healthy Interest coverage ratio. More than 25x in
the past three years.
# 29. Debt Service Coverage

Ratio (DSCR)
What is DSCR?
Debt Service Coverage Ratio tells us whether the Operating Income
is sufficient to pay off all obligations that are related to debt in a
year. It also includes committed lease payments. Debt servicing
consists of not only the interest but also some principal portion also
is repaid annually.
Formula
Debt Service Coverage Formula = Operating Income / Debt Service
Operating Income is nothing but EBIT

Debt Service is Principal Payments + Interest Payments + Lease
Payments
Example
Let us take a simple DSCR calculation example,
 EBIT = $500
 Pricipal Payment = $125
 Interest Payment = $50
 Lease Payments = $25
 Debt Service = $125 + $50 + %25 = $200
DSCR = EBIT / Debt Service = $500/$200 = 2.5x
 A DSCR of less than 1.0 implies that the operating cash flows
are not sufficient enough for Debt Servicing, implying negative
cash flows.
 This is a pretty useful matrix from the Bank’s point of view,
especially when they give loans against property to individuals.
Colgate Case Study

Colgate’s Debt Service Coverage Ratio = Operating Income / Debt
Service
Debt Service = Principal Repayment of Debt + Interest Payment +

Lease Obligations
For Colgate, we get the Debt service obligations from its 10K
reports.
Please note that you get the estimate of the Debt Service in the 10K
reports.
For finding out the historical Debt Service Payments, you need to
refer to the 10Ks prior to 2020.
Colgate 10K 2020, pg 46.
Debt Service Coverage Ratio or DSCR for Colgate is healthy at
around 6.62x for 2020.
However, the DSCR has deteriorated a bit in the recent past.
You can click here for a detailed, in-depth article on DSCR Ratio
External Liquidity Risk

#30 – Bid-Ask Spread
What is Bid-Ask Spread?
Bid-Ask Spread is a very important parameter that helps us
understand how the stock prices get affected by the purchase or
sale of stocks. The bid is the highest price that the buyer is willing to
pay. Ask is the lowest price at which the seller is willing to sell.
Example
Let us take a simple Bid-Ask Spread calculation example.
If the bid price is $75 and the asking price is $80, then the bid-ask
spread is the difference between the ask price and the bid price.$80
– $75 = $5.
 External market liquidity is an important source of risk to
investors.
 If the bid-ask spread is low, then the investors are able to buy
or sell assets with little price changes.
 Also, another factor of external market liquidity is the dollar
value of shares traded.
Colgate Case Study

Let us look at Colgate Bid-Ask Spread.
As we note from the below snapshot, Bid = 78.61 and Ask = $80.30
Bid Ask Spread = 80.30 – 78.61 = 1.69
source: Yahoo Finance
#31 – Trading Volume

What is Trading Volume?
Trading volume refers to the average number of shares traded in a
day or over a period of time. When the average trading volume is
high, this implies that the stock has high liquidity (can be easily
traded). Numerous buyers and sellers provide liquidity.
Example
Let us take a simple Trading Volume example.
There are two companies – Company A and B. The average daily
traded volume of Company A is 1000, and that of Company B is 1
million.
Which company is more liquid? Obviously, company B, as there is

more investor’s interest, and traded more.
 If the trading volume is high, then investors will show more
interest in the stock that may help in an increase in the share price.
 If the trading volume is low, then fewer investors will have an
interest in the stocks. Such stock will be less expensive due to the
unwillingness of investors to buy such stocks.
Colgate Case Study
Let us look at the trading volume of Colgate. We note from the
above graph that Colgate traded volume was at around 4.165
million shares. This is a fairly liquid stock.
Growth Analysis
The growth rate is one of the most important parameters when we
look at analyzing a company. As a company becomes bigger and
bigger, its growth tapers and reaches a long-term sustainable
growth rate. In this, we discuss how sustainable growth rates are
important.
#32 – Sustainable Growth

What is Sustainable Growth?
The company’s sustainable topline growth is one of the most
important parameters for investors as well as creditors in ratio
analysis. It helps the investor forecast the growth in earnings and
valuations.
It is important to find the sustainable growth rate of the company.

The sustainable growth rate is a function of two variables:
 What is the rate of return on equity (which gives the maximum

possible growth)?
 How much of that growth is put to work through earnings
retention (rather than being paid out in dividends)?
Formula
Sustainable Growth Rate Formula = ROE x Retention rate
Example
Let us take a simple Sustainable Growth calculation example.
 ROE = 20%
 Dividend Payout ratio = 30%
Sustainable Growth Rate = ROE x Retention Rate = 20% x (1-0.3) =

14%
 If the company is not growing, then there can be greater
chances of default on the debt. Company’s growth phase is
generally divided into three parts – Hypergrowth period, Maturity
Phase, Decline Phase
 The Sustainable Growth rate formula is primarily applicable
in the Mature Phase.
Colgate Case Study

Let us now look at the sustainable growth rate of Colgate.
Sustainable. We note that the sustainable ROE as per the formula
comes out to be around 133.2% in 2020. For all earlier years, it is in
excess of 200% (which seems highly unlikely). Due to recent
volatility in foreign exchange (leading to sales volatility) and
buybacks done by the management (leading to an increase in ROE),
sustainable growth is not making sense here.
Conclusions
Now that we have calculated all 32 ratios, you should appreciate
that ratio analysis includes learning about the company from all
dimensions. A single ratio does not provide us with a full
understanding of the company. All the ratios need to be looked at
cohesively and are interconnected. We noted that Colgate has been
an amazing company with solid fundamentals.

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Ratio Analysis

Introduction to Ratio Analysis

Objectives of Ratio Analysis

1. Helps in Measuring the Profitability of the

2. Helps in Evaluating Operational Efficiency

4. Determining Financial Health

Limitations of Ratio Analysis

1. Use of Historical Data

2. The Concept of Inflation

3. The Problem of Aggregation

5. The Policies of Accounting

6. No Standard Definition of Ratios

7. Ignorance of the Qualitative Aspect

8. Opportunities for Window Dressing

9. The Mix of Historical and Actual Numbers

10. Time Effect

Framework for Ratio Analysis

Vertical Analysis – Income Statement

Colgate Case Study

What can we interpret with Vertical Analysis of Colgate?

 Vertical Ratio Analysis helps us with analyzing historical trends.

Colgate Case Study

Interpretation of Colgate’s Vertical Analysis

 On the liabilities side, there can be many observations we can

Colgate Case Study

What can we interpret with Horizontal Analysis of Colgate

 In 2020, Colgate’s new sales growth increased by 5%. Why?

Colgate Case Study

 We note that Sales have increased by only 8.4% over a period

Liquidity ratio analysis measure how liquid the company’s assets are

 Current Assets = $200 Current Liabilities = $100

Colgate Case Study

 Colgate’s current ratio has deteriorated over the past 5 years.

source: Colgate 2020 10K Report, Pg – 125

#5 – Quick Ratio Analysis

The rule of thumb for a healthy acid test index is 1.0.

 Cash and Cash Equivalents = $100

Then Quick Ratio = ($100 + $500) / $1000 = 0.6x

Colgate Case Study

The Quick Ratio of Colgate is also decreasing (similar to the current

#6 – Cash Ratio analysis

 Cash and Cash Equivalents = $500

Then Quick Ratio = $500 / $1000 = 0.5x

Colgate Case Study

Colgate’s cash ratio has decreased from 0.45x in 2017 to 0.20x in

However, when we look at Turnover ratio analysis, we try to analyze

The commonly used turnover ratios include:

#7 – Receivables Turnover Ratio

Accounts Receivables can be calculated for the full year or for a

Accounts Receivables Turnover = $800 / $200 = 4.0x

Colgate Case Study

 We note that the Receivables Turnover was above 10x in 2016-

You may calculate Account Receivable days based on the year-end

 Accounts Receivables Turnover = 4.0x

Days Receivables = 365 / 4.0x = 91.25 days ~ 91 days

This implies that it takes 91 days for the company to convert

Colgate Case Study

 This means that Colgate is doing a better job of collecting its

#9 – Inventory Turnover Ratio

Let us take a simple Inventory Turnover Ratio Calculation example.