FINANCIAL RATIO ANALYSIS

PRESENTED BY GROUP B
 CONTENTS
1) Introduction
2) Ratios and Ratio Analysis
3) Uses and Users of Financial Ratio Analysis
4) Rationale of using Ratio Analysis
5) Procedure for Computation of Ratios
6) Advantages of Ratio Analysis
7) Limitations of Ratio Analysis
8) Types of Ratio Analysis
a) Liquidity Ratios
b) Leverage Ratios
c) Profitability Ratios
d) Activity or Efficiency Ratios
e) Growth Ratios
f) Integrated Ratios
9) Conclusion
 INTRODUCTION
Financial statements aim at providing financial information about a business enterprise to meet the
information needs of the decision-makers. Financial statements provide financial data which require
analysis, comparison and interpretation for taking decision by the external as well as internal users
of accounting information. This act is termed as financial statement analysis. It is regarded as an
integral and important part of accounting.
The most commonly used techniques of financial statements analysis are
comparative statements, common size statements, trend analysis, accounting ratios and cash
flow analysis. Here in this presentation, we are going to discuss the technique of accounting
ratios for analyzing the information contained in financial statements for assessing the
solvency, efficiency and profitability of the enterprises. The theory of financial ratios was
made popular by Benjamin Graham, who is popularly known as the fundamental analysis
father.
Here in this presentation, we are going to discuss the technique of accounting ratios for
analyzing the information contained in financial statements for assessing the solvency, efficiency
and profitability of the enterprises. The theory of financial ratios was made popular by Benjamin
Graham, who is popularly known as the fundamental analysis father.
 RATIOS AND RATIO ANALYSIS
• A ratio is a mathematical number calculated as a reference to relationship of two or more
numbers/items/variables. This relationship can be expressed as-
i. Percentages, say, net profits are 25 per cent of sales (assuming net profits of Rs. 25,000 and sales of Rs.
1,00,000).
ii. Fraction (net profit is one-fourth of sales)
iii. Proportion of numbers (the relationship between net profits and sales is 1:4)
• These alternative methods of expressing items which are related to each other are, for purposes of financial
analysis referred to as Ratio Analysis.
• A sustainable business and mission requires effective planning and financial management. Ratio analysis is a
very powerful analytical tool useful for measuring performance of an organization. It can be used to compare
the risk and return relationships of firms of different sizes.
• It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and
weaknesses of a firm as well as its historical performance and current financial conditions can be determined.
• Ratio analysis enables the users like shareholders, investors, creditors, Government, and analysts etc. to get
better understanding of the financial statements.
• It should be noted that computing these ratios does not add any further information which is not already inherent in the
above figures of profits and sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to
enable equity research analysts, investors, asset managers and lenders evaluate the overall financial health of businesses,
with the end goal of making better investment and credit decisions.
• Corporate finance ratios are also heavily used by financial managers and C-suite officers to obtain an improved
understanding of how their businesses are performing.
• Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful
information about a company. The numbers found on a company’s financial statements – balance sheet, income
statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity,
leverage, growth, margins, profitability, rates of return, valuation, and more.
• For ratios to be useful and meaningful, they must be:
a) Calculated using reliable, accurate financial information and also consistently from period to period.
b) Calculated Used in comparison to internal benchmarks and goals
c) Used in comparison to other companies in your industry
d) Viewed both at a single point in time and as an indication of broad trends and issues over time
e) Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in
assessing performance.
 USES AND USERS OF FINANCIAL
RATIO ANALYSIS
• Analysis of financial ratios serves two main purposes:
1. Track company performance:
Determining individual financial ratios per period and tracking the change in their values over time is done to spot
trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a
company is overburdened with debt and may eventually be facing default risk.
2. Make comparative judgments regarding company performance:
Comparing financial ratios with that of major competitors is done to identify whether a company is performing
better or worse than the industry average. For example, comparing the return on assets between companies helps
an analyst or investor to determine which company is making the most efficient use of its assets.

• Users of financial ratios include parties external and internal to the company:
o External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory
authorities, and industry observers.
o Internal users: Management team, employees, and owners.
 RATIONALE OF USING RATIO ANALYSIS
• The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no
meaning but when expressed in terms of a related figure, it yields significant inferences. For instance, the fact that the net
profits of a firm amount to say, Rs. 10 lakhs throws no light on its adequacy. The figure of net profit has to be considered in
relation to other variables. If net profits are shown in terms of their relationships with items such as sales, assets, capital
employed, equity capital and so on, then meaningful conclusions can be drawn regarding their adequacy.
• Ratio analysis is not just comparing different numbers from the balance sheet, income statement and cash flow statement. It is
comparing the number against previous years, other companies, the industry, or even the economy in general for the purpose of
financial analysis.
• Ratio analysis is a great way to compare two companies that are different in size operations and management style. It also is a
great way to quantify how efficient a company’s operations are and how profitable the business is set up to be. Solvency ratios,
for example, can be used to analyze how well a company will be able to meet their financial obligations. It is a technique which
involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter.
• It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it
provides a lot of information which helps the analyst:
(i) To know the areas of the business which need more attention;
(ii) To know about the potential areas which can be improved with the effort in the desired direction;
(iii) To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
(iv) To provide information for making cross-sectional analysis by comparing the performance with the best industry
standards; and
(v) To provide information derived from financial statements useful for making projections and estimates for the future.
 PROCEDURE FOR COMPUTATION OF RATIOS

• Generally, ratio analysis involves four steps:

(i) Collection of relevant accounting data from financial statements.

(ii) Constructing ratios of related accounting figures.
(iii) Comparing the ratios thus constructed with the standard ratios which may be the
corresponding past ratios of the firm or industry average ratios of the firm or ratios of
competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.
 ADVANTAGES OF RATIO ANALYSIS
There are many advantages derived from ratio analysis. These are summarized as follows:
1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand whether the business firm
has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in
improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting figures
and bring out their relationships. They help summarize the financial information effectively and assess the
managerial efficiency, firm’s credit worthiness, earning capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year figures are
kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps
in making projections about the business which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the bright areas
of the business. Problem areas would need more attention and bright areas will need polishing to have still better
results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The
information of change helps the management a great deal in understanding the current threats and opportunities and
allows business to do its own SWOT (Strength-Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm’s
performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc., of a business, may be
compared: (i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis), (ii) with
other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and (iii) with standards set for that
firm/industry (comparison with standard or industry expectations).
7. Indication of Liquidity Position: Ratio analysis helps to assess the liquidity position i.e., short-term debt paying
ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors
and other suppliers of short-term loans.
8. Indication of Long-term Solvency Position: Ratio analysis is also used to assess the long-term debt-paying
capacity of a firm. Long-term solvency position of a borrower is a prime concern to the long-term creditors, security
analysts and the present and potential owners of a business. It is measured by the leverage/capital structure and
profitability ratios which indicate the earning power and operating efficiency. Ratio analysis shows the strength and
weakness of a firm in this respect.
9. Indication of Overall Profitability: The management is always concerned with the overall profitability of the
firm. They want to know whether the firm has the ability to meet its short-term as well as long-term obligations to its
creditors, to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm. This is
possible if all the ratios are considered together.
10. Signal of Corporate Sickness: A company is sick when it fails to generate profit on a continuous basis and
suffers a severe liquidity crisis. Proper ratio analysis can give signal of corporate sickness in advance so that timely
measures can be taken to prevent the occurrence of such sickness.
 LIMITATIONS OF RATIO ANALYSIS

• Ratio analysis is a widely used tool of financial analysis. Yet, it suffers from various limitations.
The operational implication of this is that while using ratios, the conclusions should not be taken
on their face value. Some of the limitations which characterize ratio analysis are
(i) Changes in price level,
(ii) Difficulty in comparison
(iii) Impact of inflation
(iv) Conceptual diversity
(v) Window-dressing and
(vi) Seasonal factors affecting financial data etc.

o Changes is price level: Fixed assets show the position statement at cost only. Hence, it does not
reflect the changes in price level. Thus, it makes comparison difficult.
o Difficulty in Comparison:
• One serious limitation of ratio analysis arises out of the difficulty associated with their comparability. One technique that is
employed is inter-firm comparison. But such comparisons are vitiated by different procedures adopted by various firms.
The differences may relate to:
✓ Differences in the basis of inventory valuation (e.g. last in first out, first in first out, average cost and cost)
✓ Different depreciation methods (i.e. straight line vs written down basis);
✓ Estimated working life of assets, particularly of plant and equipment;
✓ Amortization of intangible assets like goodwill, patents and so on;
✓ Amortization of deferred revenue expenditure such as preliminary expenditure and discount on issue of shares;
✓ Capitalization of lease;
✓ Treatment of extraordinary items of income and expenditure; and so on.
• Secondly, apart from different accounting procedures, companies may have different accounting periods, implying
differences in the composition of the assets, particularly current assets. For these reasons, the ratios of two firms may not be
strictly comparable.
• Another basis of comparison is the industry average. This presupposes the availability, on a comprehensive scale, of various
ratios for each industry group over a period of time. If, however, as is likely, such information is not compiled and
available, the utility of ratio analysis would be limited.
o Impact of Inflation:
• The second major limitation of the ratio analysis as a tool of financial analysis is associated with price level
changes. This, in fact, is a weakness of the traditional financial statements which are based on historical costs.
An implication of this feature of the financial statements.as regards ratio analysis is that assets acquired at
different periods are, in effect, shown at different prices in the balance sheet, as they are not adjusted for
changes in the price level. As a result, ratio analysis will not yield strictly comparable and, therefore,
dependable results.
• To illustrate, there are two firms which have identical rates of returns on investments, say 15 per cent. But one
of these had acquired its fixed assets when prices were relatively low, while the other one had purchased them
when prices were high. As a result, the book value of the fixed assets of the former type of firm would be
lower, while that of the latter higher. From the point of view of profitability, the return on the investment of the
firm with a lower book value would be overstated. Obviously, identical rates of returns on investment are not
indicative of equal profitability of the two firms. This is a limitation of ratios.
o Conceptual Diversity:
• Yet another factor which influences the usefulness of ratios is that there is difference of opinion regarding the
various concepts used to compute the ratios. There is always room for diversity of opinion as to what constitutes
shareholders’ equity, debt, assets, profit and
• so on. Different firms may use these terms in different senses or the same firm may use them to mean different
things at different times.
• Reliance on a single ratio for a particular purpose may not be a conclusive indicator. For instance, the current ratio
alone is not a adequate measure of short-term financial strength; it should be supplemented by the acid-test ratio,
debtors turnover ratio and inventory turnover ratio to have a real insight into the liquidity aspect.
• Finally, ratios are only a post-mortem analysis of what has happened between two balance sheet dates. For one
thing, the position in the interim period is not revealed by ratio analysis. Moreover, they give no clue about the
future.
• In brief, ratio analysis suffers from some serious limitations. The analyst should not be carried away by its
oversimplified nature, easy computation with a high degree of precision. The reliability and significance attached to
ratios will largely depend upon the quality of data on which they are based. They are as good as the data itself.
Nevertheless, they are an important tool of financial analysis.
o Window-Dressing: The term ‘window-dressing’ means presenting the financial statements in such a
way to show a better position than what it actually is. If, for instance, low rate of depreciation is
charged, an item of revenue expense is treated as capital expenditure etc. the position of the concern
may be made to appear in the balance sheet much better than what it is. Ratios computed from such
balance sheet cannot be used for scanning the financial position of the business.

o Seasonal Factors Affect Financial Data: Proper care must be taken when interpreting
accounting ratios calculated for seasonal business. For example, an umbrella company maintains high
inventory during rainy season and for the rest of year its inventory level becomes 25% of the seasonal
inventory level. Hence, liquidity ratios and inventory turnover ratio will give biased picture.
 TYPES OF
FINANCIAL
RATIOS

INTEGRATED
LIQUIDITY ANALYSIS OF
RATIOS RATIOS

CAPITAL
STRUCTURE/ GROWTH
LEVERAGE RATIOS
ACTIVITY/
RATIOS PROFITABILITY
EFFICIENCY
RATIOS
RATIOS
 LIQUIDITY RATIOS /
SHORT TERM SOLVENCY RATIOS
 WHAT ARE LIQUIDITY RATIOS?
• Liquidity ratios measure the ability of a firm to meet its short term obligations and reflect
the short term financial strength or solvency of the firm.
• The importance of adequate liquidity in the sense of the ability of a firm to meet current
short term obligations when they become due for payment can hardly be over stressed.
• Liquidity ratios are particularly interesting to short-term creditors, because financial
managers are constantly working with banks and other short-term lenders, an understanding
of these ratios is essential for them.
• A proper balance between liquidity and profitability is required for efficient financial
management.
• Some ratios which indicate liquidity of a firm are discussed hereafter.
 NET WORKING CAPITAL
• Net Working capital represents the excess of current assets over current liabilities.

𝑵𝒆𝒕 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑵𝑾𝑪 = 𝑻𝒐𝒕𝒂𝒍 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑻𝒐𝒕𝒂𝒍 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

• An enterprise should have sufficient NWC in order to be able to meet the claims of the writer
creditors and the day to day needs of business.
• Higher the NWC, higher is the liquidity of the firm.
• NWC is really not a ratio but is frequently employed as a measure of a company's liquidity
position.
 CURRENT RATIO
• The current ratio is the ratio of total current assets to total current liabilities. Just calculated
by dividing current assets by current liabilities.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
• The higher the current ratio, larger is the amount of rupees available per rupee of current
liability, the more is the firm’s ability to meet current obligations and the greater is the safety
of funds of short-term creditors.
• Therefore, the current ratio in a way is a measure of margin of safety to the creditors. Absent
some extraordinary circumstances, we would expect to see a Current Ratio of at least 1.
• A current ratio of less than 1 would mean that net working capital is negative.
• We could say ABC has $1.31 in current assets for every $1 in current liabilities, or we could
say ABC has its current liabilities covered 1.31 times over.
 PROBLEMS ON CURRENT RATIOS
Ques 1: Suppose a firm buys some inventory. What would happen to the current ratio?
Ans.
Nothing happens to the current ratio because cash goes down while inventory goes up—total
current assets are unaffected.

Ques 2: What happens to current ratio if a firm sells some merchandise?

Ans.
The current ratio would usually rise because inventory is normally shown at cost and the sale
would normally be at something greater than cost. The increase in either cash or receivables is
therefore greater than the decrease in inventory. This increases current assets, and the current
ratio rises.
 LIMITATIONS OF CURRENT RATIO

• One defect of the current ratio is that it fails to convey any information on the
composition of the current assets of a form. Rupee of cash is considered equivalent to a
rupee of inventory or receivables but it is not so.
• We can say that current ratio is a quantitative rather than a qualitative index of liquidity.
• A company may have an inconsistent current ratio if the sales are seasonal. If the sales
are low, the company will record the lowest current ratio, but the current ratio will be
high when the sales increase. The fluctuation of the current ratio will lead to a
misconception of the company liquidity.
 ACID TEST/ QUICK TEST RATIO
• The acid test ratio is the ratio between quick current assets and current liabilities and is calculated
by dividing liquid assets by the current liabilities.
𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
𝑨𝒄𝒊𝒅 𝑻𝒆𝒔𝒕 𝒐𝒓 𝑸𝒖𝒊𝒄𝒌 𝑻𝒆𝒔𝒕𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
▪ 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
• Inventory is often the least liquid current asset. Some of the inventory may later turn out to be
damaged, obsolete, or lost.
• The firm may have overestimated sales and overbought or overproduced as a result. In this case,
the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.
• Using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. To
give an example of current versus quick ratios, based on recent financial statements, Walmart and
Manpower, Inc., had current ratios of .89 and 1.12, respectively. However, Manpower carries no
inventory to speak of, whereas Walmart’s current assets are virtually all inventory. As a result,
Walmart’s quick ratio was only .27, and Manpower’s was 1.12, the same as its current ratio.
 INVENTORY TURNOVER RATIO
• It is a ratio between cost of goods sold and the average inventory during the year.

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅

𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

• Where,
▪ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 = sales minus gross profit
▪ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = simple average of the opening and closing inventory

• The ratio indicates how fast inventory is sold.

• A high ratio is good from the viewpoint of liquidity and vice versa.
 DEBTORS TURNOVER RATIO

• It is determined by dividing the net credit sales by average debtors during the year.

𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔

𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑫𝒆𝒃𝒕𝒐𝒓𝒔

• The ratio measures how rapidly receivables are collected.

• A high ratio is indicative of shorter time-lag between credit sales and cash collection.

• A low ratio shows that debts are not being collected rapidly.
 CREDITORS TURNOVER RATIO
• It is a ratio between net credit purchases and the average amount of creditors outstanding
during the year.
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
𝑪𝒓𝒆𝒅𝒊𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒓𝒆𝒅𝒊𝒕𝒐𝒓𝒔
▪ 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 = 𝐺𝑟𝑜𝑠𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑙𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑡𝑜 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑟𝑠
▪ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑎𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
• A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio
shows that accounts are to be settled rapidly.
• The creditors turnover ratio is an important tool of analysis as a firm can reduce its
requirement of current assets by relying on supplier’s credit.
• The extent to which trade creditors are willing to wait for payment can be approximated by
this ratio.
 NUMERICAL PROBLEM
Ques 1: A firm has sold goods worth Rs. 3,00,000 with a gross profit margin of 20 per cent.
The stock at the beginning and the end of the year was Rs. 35,000 and Rs. 45,000
respectively. What is the inventory turnover ratio?
3,00,000−60,000
Ans.: Inventory turnover ratio = ( 35,000+45,000 ÷2)
= 6(times per year)
12 𝑚𝑜𝑛𝑡ℎ𝑠
Inventory holding period = = 2 𝑚𝑜𝑛𝑡ℎ𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜,6

Ques 2: A firm has made credit sales Rs. 2,40,000 during the year. The outstanding amount
of debtors at the beginning and at the end of the year respectively was Rs. 27,500 and Rs
32,500. Determine the debtors turnover ratio.
2,40,000
Ans.: Debtors turnover ratio = ( 27,500+37,500 ÷2)
= 8(times per year)
12 𝑚𝑜𝑛𝑡ℎ𝑠
Debtors collection period = = 1.5 𝑚𝑜𝑛𝑡ℎ𝑠
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜, 8
 NUMERICAL PROBLEM
Ques 3: A firm has made credit purchases of Rs 1,80,000. The amount payable to the creditors at
the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the
creditors turnover ratio.
1,80,000
Ans.: Creditors turnover ratio = ( 42,500+47,500 ÷2)
= 4(times per year)
12 𝑚𝑜𝑛𝑡ℎ𝑠
Creditors payment period = = 3 𝑚𝑜𝑛𝑡ℎ𝑠
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜, 4
_______________________________________________________________________________
The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity
of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and
payment to creditors. The combined effect of the three turnover ratios is summarized below:
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑: 2 𝑚𝑜𝑛𝑡ℎ𝑠
Add: 𝐷𝑒𝑏𝑡𝑜𝑟 ′ 𝑠 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑: + 1.5 𝑚𝑜𝑛𝑡ℎ𝑠
Less: 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟 ′ 𝑠 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑: − 3 𝑚𝑜𝑛𝑡ℎ𝑠 𝑻𝒐𝒕𝒂𝒍 = 𝟎. 𝟓 𝒎𝒐𝒏𝒕𝒉𝒔
 DEFENSIVE INTERVAL RATIO
• It is a ratio between the quick/liquid assets and the projected daily cash requirements.

𝑳𝒊𝒒𝒖𝒊𝒅 𝑨𝒔𝒔𝒆𝒕𝒔
𝑫𝒆𝒇𝒆𝒏𝒔𝒊𝒗𝒆 𝑰𝒏𝒕𝒆𝒓𝒗𝒂𝒍 𝑹𝒂𝒕𝒊𝒐 =
𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒆𝒅 𝑫𝒂𝒊𝒍𝒚 𝑪𝒂𝒔𝒉 𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒊𝒐𝒏𝒔

𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒆𝒅 𝑪𝒂𝒔𝒉 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆

𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒆𝒅 𝑫𝒂𝒊𝒍𝒚 𝑪𝒂𝒔𝒉 𝑷𝒓𝒐𝒋𝒆𝒄𝒕𝒊𝒐𝒏𝒔 =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓 (𝟑𝟔𝟓)

• The liquidity position of a firm should also be examined in relation to its ability to meet
projected daily expenditure from operations.
• The defensive-interval ratio measures the timespan a firm can operate on present liquid
assets without resorting to next year’s income.
 NUMERICAL PROBLEM
Ques: The projected cash operating expenditure of a firm from the next year is Rs 1,82,500.
It has liquid cash assets amounting to Rs 40,000. Determine the defensive-interval ratio.
Ans:
1,82,500
𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐷𝑎𝑖𝑙𝑦 𝐶𝑎𝑠ℎ 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = = 𝑅𝑠. 500
365
40,000
𝐷𝑒𝑓𝑒𝑛𝑠𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = = 80 𝑑𝑎𝑦𝑠
500
A higher ratio would be favorable as it would reflect the ability of a firm to meet cash
requirements for a longer period of time. It provides a safety margin to the firm in
determining it’s ability to meet basic operational costs. A higher ratio would provide the
firm with a relatively higher degree of protection and tends to offset the weakness indicated
by the low current and acid-test ratios.
 CASH FLOW FROM OPERATIONS
RATIO
• This ratio measures liquidity of a firm by comparing actual cash flows from
operations with current liability.
𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
𝑪𝒂𝒔𝒉𝒇𝒍𝒐𝒘 𝒇𝒓𝒐𝒎 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
• Being a cash measure, the ratio does not encounter the problems of actual
convertibility of current assets and the need for maintaining minimum levels of
these assets.
• Higher the ratio, the better is a firm from the point of view of liquidity.
 CAPITAL STRUCTURE/
LEVERAGE RATIOS/ LONG-TERM
SOLVENCY RATIOS
 WHAT ARE LEVERAGE RATIOS?
• Long term investors analyze the soundness of a company in terms of its long-term financial strength which
is measured in terms of:
• Ability of the firm to pay interests regularly.
• Ability of the firm to repay back the principle (in lump sum at time of maturity or in predetermined
instalments on due dates.)
• Or in other words, this ratio examines the long-term solvency of firms.
• Thus, the two aspects of long- term solvency have two types of leverage ratios accordingly:-
1) The Structural Ratios that are based on relationship between borrowed fund and owner’s capital and
are calculated from balance sheets.
a) Debt-equity ratio
b) Debt-assets ratio, etc.
2)The ratios that are calculated from PL (Profit and Loss) account and are called Coverage Ratios.
a) Interest coverage ratio
b) Dividend coverage ratio
c) Total fixed charges coverage ratio
d) Debt-services coverage ratio
 STRUCTURAL RATIOS
➢DEBT TO EQUITY RATIO
This ratio reflects the relative claim of creditors and shareholders against the asset of firm. The relationship between
outsiders claims and owners’ capital can be shown in many ways and thus there are many variants of the D/E Ratio.
𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒅𝒆𝒃𝒕
D/E Ratio =
𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔𝒆𝒒𝒖𝒊𝒕𝒚
Here, debt is exclusive of current liabilities.

Shareholder’s equity includes : equity & preference share capital, past accumulated profits but excludes fictitious
assets like past accumulated loss, discount on share issue, etc.

𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕
D/E Ratio =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚

It is basically the ratio of amount invested by outsiders to amount invested by owners of the business. The
difference between these 2-approach is that the former excludes current liabilities while the latter includes that.
The omission of current liabilities would lead to misleading results.
Here’s why:-

• Though current liabilities are of short term, their amount fluctuates widely during a year
and interest payments on them are not large, as a whole a fixed amount of them is always
in use. So, they should form a part of total outside liabilities to determine ability of firm to
meet long term obligations.
• Some current liabilities like bank credit, which are renewed year after year and remain
permanently in business.
• Current liabilities have a prior right on assets of business and paid along with long term
lender at time of liquidation of firm.
• Short term creditors exercise as much exercise on management.
 INTERPRETATION :
• A high D/E ratio implies large share of financing by creditors of firm and vice versa.
• This ratio indicates margin of safety of investors.
• If the D/E ratio is 1:2, it means for every rupee of outside liability, firm owner has two rupees share
in finance of the company i.e. there is a safety margin of 66.67%. the firm would be able to meet
creditor’s claim even if value of assets fall by 66.67%.
• Similarly, a D/E ratio of 2:1 implies a low safety margin for creditors, which is a danger signal.
Because:
i. If the project fails, creditors would lose heavily.
ii. With a lower investment of owners, they may behave speculatively and irresponsibly.
iii. Inflexibility in operation of firm as creditors with higher investment would interfere in
management.
iv. Such a firm would be able to borrow only under restrictive terms and conditions
v. Heavy burden on interest payment is faced, especially when profits decline.
Shareholders would gain in two ways:
• Retain control of firm by holding limited stakes
• Return to them would be magnified.
• This is leverage or trading on equity. If the return on borrowed fund is more than fixed
charge of debt, shareholders gain. And the leverage moves in opposite direction if return on
borrowed fund is less than fixed charge. It is basically the practice of using borrowed funds
that carry fixed charge to obtain higher return on equity holders. Since debt carries fixed rate
of return, if the firm earns higher return on borrowed fund than fixed charge on loan, it is
shareholders who gain.
However, both high and low D/E ratio is not desirable. The ratio should strike a balance
between debt and equity.
➢DEBT TO ASSETS RATIO:
It indicates the percentage of assets that are being financed with debt. The higher the ratio,
the greater the degree of leverage and financial risk.
𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕
Debt to Assets Ratio=
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
i.e., share of total assets financed by outside firms. The debt here is long term as well as short
term . This implies:
𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕
Debt to Assets Ratio =
𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕
𝑫𝒆𝒃𝒕/𝑬𝒒𝒖𝒊𝒕𝒚
= [On dividing by equity]
𝟏+𝑫𝒆𝒃𝒕/𝑬𝒒𝒖𝒊𝒕𝒚
Investors use the ratio to make sure the company is solvent, is able to meet current and future
obligations, and can generate a return on their investment. Companies with a higher ratio are
more leveraged and, hence, riskier to invest in and provide loans to. If the ratio steadily
increases, it could indicate a default at some point in the future.
For the following balance sheet, we can calculate the structural ratios as follows:
 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
D/E Ratio = Debt to Assets Ratio =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Secured + unsecured loans Secured + unsecured loans
= =
𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒 & 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡+𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡

= (21+25) / (16+22) = 46 / (60+23.40)

= 46 / 38 = 46/83.4
= 1.2105 = 0.55
= 2.875
The secured loans refer to those loans which are obtained against any mortgage or collateral. Unsecured
loans are those that do not include any mortgage or collateral.
Reserves and surplus refer to accumulated profit of a company over the years.
Finally, the results imply , the company owns more assets than liabilities and can meet its obligations by
selling its assets if needed. The lower the debt to asset ratio, the less risky the company.
 COVERAGE RATIO

Coverage ratios measure the firm’s ability to pay certain fixed charges. The soundness of a
firm, from the view-point of long-term creditors, lies in its ability to service their claims, i.e,
obligations of a firm which are normally met out of the earnings or operating profits. These
claims consist of : interest on loans, preference dividend, repayment of principal.
➢Interest Coverage Ratio:
It measures firm’s ability to make contractual interest payments.
𝑬𝑩𝑰𝑻
It is given by, ICR=
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒉𝒂𝒓𝒈𝒆 𝒐𝒏 𝒍𝒐𝒂𝒏𝒔
EBIT stands for earning before interest and tax.
This ratio indicates the extent to which a fall in EBIT is tolerable in that the ability of the firm
to service its interest payments would not be adversely affected.
From the point of view of the lenders, the larger the coverage, the greater is the ability of the firm to
handle fixed-charge liabilities and the more assured is the payment of interest to them. However, too
high a ratio may imply unused debt capacity. In contrast, a low ratio is a danger signal that the firm
is using excessive debt and does not have the ability to offer assured payment of interest to the
lenders.

But, this is not an appropriate measure because the source of interest payment is cash flow before
interest and tax payment and not profit before interest and tax. Therefore, a better representation of
this ratio is,
𝑬𝑩𝑰𝑻+𝑫𝒆𝒑𝒓𝒊𝒄𝒊𝒂𝒕𝒊𝒐𝒏
ICR =
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒉𝒂𝒓𝒈𝒆 𝒐𝒏 𝒍𝒐𝒂𝒏𝒔
Eg: Suppose that a company have:
• earnings during a given quarter = $625,000
• debts upon which it is liable for payments of $30,000 every month.
Therefore,
Interest coverage ratio= $625,000 / $90,000 ie, ($30,000 x 3) = 6.94.
This indicates the company has no current problems with liquidity.
➢Dividend Coverage Ratio (DCR):

It measures the ability of firm to pay dividends on preference shares .

𝑬𝑨𝑻
It is given by, DCR =
𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
Where, EAT= earnings after tax.
Here we consider EAT because unlike debt on which interest is a charge on profits of firm, preference dividend is
treated as appropriation of profit.
This ratio reveals safety margin of preference shareholders. The higher the coverage , better it is.
For example, let a company have following figure:
• Profit before tax: $500,000
• tax rate: 30%
• Dividend to preferred shareholders: $20,000
Therefore, DCR= [500000- (30% of 500000)] / 20000
= 17.5
It means the earnings generated by the company are very good enough to serve shareholders with their dividends.
➢Total Fixed Charge Coverage Ratio (FCCR):

This takes into consideration all the committed fixed obligations of a firm which includes:
interest on loans, preference dividend, lease payment, repayment of principal.
It is a measure of a company’s ability to meet fixed-charge obligations such as interest
expenses and lease expenses. The FCCR is a broader measure of the interest coverage ratio,
more complete by virtue of the fact that it also includes other fixed costs such as leases.
It’s given by,

𝑬𝑩𝑰𝑻+𝑳𝒆𝒂𝒔𝒆 𝑷𝒂𝒚𝒎𝒆𝒏𝒕
FCCR=
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕+𝒍𝒆𝒂𝒔𝒆 𝒑𝒂𝒚𝒎𝒆𝒏𝒕+ (𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅+𝒊𝒏𝒔𝒕𝒂𝒍𝒎𝒆𝒏𝒕 𝒐𝒇 𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍)/ (𝟏−𝒕)
Eg: let for a company ,
• EBIT= 500000
• Monthly lease payments =5,000
• Annual interest payments = 30,000
• Annual principal repayments =20,000
• Dividend to preferred shareholders: 20,000
• tax rate: 30%
Therefore,
500000+ 5000∗12
FCCR=
30000+ 5000∗12 +(20000+20000)/(1−0.3)
560000
= 90000+57,142.857
560000
= 1,47,142.857
= 3.805
This means that the company can pay for its fixed charges more than 3 times over.
➢Debt Services Coverage Ratio (DSCR):
It analyses the debt service capacity of a firm. That is, ability to make contractual
payments required over schedules basis. It gives the result in terms of no. of times total
debt service obligations are covered by total operating funds available after-tax
payments.
It’s given by,
σ𝒏
𝒕=𝟏 𝑬𝑨𝑻 +𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 +𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏+𝑶𝒕𝒉𝒆𝒓 𝑵𝒐𝒏 𝑪𝒂𝒔𝒉 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆
DSCR =
σ𝒏𝒕=𝟏 𝑰𝒏𝒔𝒕𝒂𝒍𝒎𝒆𝒏𝒕

Higher the ratio, better it is.

It is used to understand how easily a company’s operating cash flow can cover its
annual interest and principal obligations.
PROFITABILITY RATIOS
 WHAT ARE PROFITABILITY RATIOS?
Profitability ratios are a class of financial metrics that are used to assess a
business's ability to generate earnings relative to its revenue, operating costs,
balance sheet assets, or shareholders' equity over time, using data from a specific
point in time.
PROFITABILITY RATIOS

In Relation to Sales In Relation to Investment

Return on
Return on Capital
Gross Profit Margin Net Profit Margin Expenses Ratio Return on Assets Shareholders’
Employed
Equity
 PROFITABILITY RATIOS RELATED TO SALES
These ratios are based on the premise that a firm should earn sufficient profit on each rupee of sales. If adequate profits
are not earned on sales, there will be difficulty in meeting the operating expenses and no returns will be available to the
owners.

o Profit Margin: he profit margin measures the relationship between profit and sales. As the profits may be gross
or net, there are two types of profit margins: Gross profit margin and Net profit margin
o Gross Profit Margin: It is also known as gross margin. It is calculated by dividing gross profit by sales. Thus.
𝒈𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕
Gross profit margin = x 100
𝒔𝒂𝒍𝒆𝒔

o Net Profit Margin: It is also known as net margin. This measures the relationship between net profits and sales
of a firm. Depending on the concept of net profit employed, this ratio can be computed in three ways:
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐛𝐞𝐟𝐨𝐫𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱𝐞𝐬
1. Operating profit ratio=
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐛𝐞𝐟𝐨𝐫𝐞 𝐭𝐚𝐱𝐞𝐬
2. Pre-tax profit ratio=
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐚𝐟𝐭𝐞𝐫 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐭𝐚𝐱𝐞𝐬
3. Net profit ratio=
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
oExpenses Ratio:
Another profitability ratio related to sales is the expenses ratio. It is computed by dividing expenses by sales. The term
‘expenses’ includes-(i) cost of goods sold, (ii) administrative expenses, (iii) selling and distribution expenses, (iv) financial
expenses but excludes taxes, dividends and extraordinary losses due to theft of goods, good destroyed by fire and so on.
There are different variants of expenses ratios. That is,
𝑪𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅
• Cost of goods sold ratio= X 100
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝐀𝐝𝐦𝐢𝐧𝐬𝐢𝐭𝐫𝐚𝐭𝐢𝐯𝐞 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬+𝐒𝐞𝐥𝐥𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
• Operating expenses ratio= X 100
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝑨𝒅𝒎𝒊𝒏𝒊𝒔𝒕𝒓𝒂𝒕𝒊𝒗𝒆 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
• Administrative expenses ratio= X 100
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝐒𝐞𝐥𝐥𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
• Selling expenses ratio= X 100
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 + 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬
• Operating ratio= X 100
𝐍𝐞𝐭 𝒔𝒂𝒍𝒆𝒔
𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
• Financial expenses ratio= X 100
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔
 NUMERICAL PROBLEM
Company ABC ltd manufactures customised skates where the total equity capital is Rs. 12 crores. At the
end of the financial year, the total assets are Rs. 45 lakhs and also current liabilities is Rs. 8 lakhs, and
the income statement looks like below –
Particulars Amount (Rs.)

Total Sales 500,000

Cost of Goods Sold 130,000

Gross Profit 370,000

Salary Expenses 110,000

Selling Expenses 70,000
Interest 10,000
Depreciation 25000
Taxes 4000
Net Profit 151,000
 The following table shows the calculation of the profitability ratios:
Ratio Formula Calculation Result

Gross Profit Margin Gross Profit Margin = Gross Profit = 370,000/ 500,000 74%
/ Net Sales

Net Profit Margin Net Profit Ratio = EAT / Net Sales = 151,000 / 500,000 30.2%
Pre-tax profit ratio = EBT/ Net
sales
=155000/500,000 31%
Operating profit ratio = EBIT/ Net
sales
=165000/500,000 33%

Return on Equity ROE = Net Profit after Taxes / = 151,000 / 12,00,00,000 1.25%
Shareholder’s Equity
Return on Assets ROA = Net Profit after Taxes / = 151,000 / 45,00,000 3.35%
Total Assets
ROA = Net Profit after Taxes
=151,000+10,000/ 3.58%
+Interest / Total Assets
45,00,000

Return on Capital Employed ROCE = EBIT / Capital Employed EBIT = 151,000 – 10,000 – 4000 = 4.08%
165,000
ROCE = 165,000 / (45,00,000 –
800,000)
oGross Profit :
• Gross profit is the result of the relationship between prices, sales volume and costs. A change in the gross
margin can be brought about by changes in any of these factors. The gross margin represents the limit beyond
which fall in sales prices are outside the tolerance limit. Further, the gross profit ratio/margin can also be used
in determining the extent of loss caused by theft, spoilage, damage, and so on in the case of those firms which
follow the policy of fixed gross profit margin in pricing their products.
• A high ratio of gross profit to sales is a sign of good management as it implies that the cost of production of the
firm is relatively low. It may also be indicative of a higher sales price without a corresponding increase in the
cost of goods sold
• A relatively low gross margin is definitely a danger signal, warranting a careful and detailed analysis of the
factors responsible for it. The important contributory factors may be-
(i) a high cost of production reflecting acquisition of raw materials and other inputs on unfavorable terms,
inefficient utilisation of current as well as fixed assets, and so on; and
(ii) a low selling price resulting from severe competition, inferior quality of the product, lack of demand,
and so on.
• A firm should have a reasonable gross margin to ensure adequate coverage for operating expenses of the firm
and sufficient return to the owners of the business, which is reflected in the net profit margin.
oThe Net Profit Margin:
• The net profit margin is indicative of management’s ability to operate the business with sufficient
success not only to recover from revenues of the period, the cost of merchandise or services, the
expenses of operating the business (including depreciation) and the cost of the borrowed funds, but
also to leave a margin of reasonable compensation to the owners for providing their capital at risk.
The ratio of net profit (after interest and taxes) to sales essentially expresses the cost price
effectiveness of the operation.
• A high net profit margin would ensure adequate return to the owners as well as enable a firm to
withstand adverse economic conditions when selling price is declining, cost of production is rising
and demand for the product is falling.
• A low net profit margin has the opposite implications. However, a firm with a low profit margin, can
earn a high rate of return on investments if it has a higher inventory turnover. This aspect is covered
in detail in the subsequent discussion. The profit margin should, therefore, be evaluated in relation to
the turnover ratio. In other words, the overall rate of return is the product of the net profit margin and
the investment turnover ratio. Similarly, the gross profit margin and the net profit margin should be
jointly evaluated.
• The gross margin may show a substantial increase over a period of time but the net profit
margin may-
(i) have remained constant, or
(ii) may not have increased as fast as the gross margin, or
(iii) may actually have declined. It may be due to the fact that the increase in the
operating expenses individually may behave abnormally.

oThe Expenses Ratio :

The expenses ratio is, very important for analyzing the profitability of a firm. It should be
compared over a period of time with the industry average as well as firms of similar type. As a
working proposition, a low ratio is favourable, while a high one is unfavorable. The
implication of a high expenses ratio is that only a relatively small percentage share of sales is
available for meeting financial liabilities like interest, tax and dividends, and so on.
 PROFITABILITY RATIOS RELATED TO INVESTMENTS
o Return on Investments (ROI):
As already observed, the profitability ratios can also be computed by relating the profits of a firm to
its investments. Such ratios are popularly termed as return on investments (ROI). Return on
investments (ROI) measures the overall effectiveness of management in generating profits with its
available assets. There are three different concepts of investments in vogue in financial literature:
assets, capital employed and share- holders’ equity. Based on each of them, there are three broad
categories of ROIs. They are (i) return on assets, (ii) return on capital employed and (iii) return on
shareholders’ equity.

o Return on Assets (ROA):

Here, the profitability ratio is measured in terms of the relationship between net profits and assets.
The ROA may also be called profit-to-asset ratio. The concept of net profit may be -(i) net profits
after taxes, (ii) net profits after taxes plus interest, and (iii) net profits after taxes plus interest
minus tax savings. Assets may be defined as- (i) total assets, (ii) fixed assets, and (iii) tangible assets.
Accordingly, the different variants of the RAO are:
Net profit after taxes
Return on assets (ROA)= X100
Average total assets
The ROA based on this ratio would be an underestimate as the interest paid to the lenders is
excluded from the net profits. The real return on the total assets is the net earnings available
to owners (EAT) and interest to lenders as assets are financed by owners as well as
creditors.

Net profit after taxes+Interest

• Return on assets (ROA)= X100
Average total assets
Net profit after taxes+Interest
• Return on assets (ROA)= X100
Average tangible assets
Net profit after taxes+Interest
• Return on assets (ROA)= X100
Average fixed assets

The ROA measures the profitability of the total funds/ investments of a firm. It, however,
throws no light on the profitability of the different sources of funds which finance the total
assets. These aspects are covered by other ROIs.
o Return on Capital Employed (ROCE):
The ROCE is the second type of ROI where the profits are related to the total capital
employed. The term capital employed refers to long-term funds supplied by the lenders
and owners of the firm. First, it is equal to non-current liabilities (long-term liabilities)
plus owners’ equity. Alternatively, it is equivalent to net working capital plus fixed
assets. Second, it is equal to long-term funds minus investments made outside the firm.
𝐸𝐵𝐼𝑇
ROCE= X100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Net profit after taxes + InterestTax advantage on interest

ROCE= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
X100
o Return on Shareholders’ Equity:
While the ROCE expresses the profitability of a firm in relation to the funds supplied by the lenders and owners
taken together, the return on shareholders’ equity measures exclusively the return on the owners’ funds. The
shareholders of a firm fall into two broad groups: preference shareholders and equity shareholders. The holders of
preference shares enjoy a preference over equity shareholders in respect of receiving dividends. In other
words, from the net profits available to the shareholders, the preference dividend is paid first and whatever
remains belongs to the ordinary shareholders.
There are several measures to calculate the return on shareholders equity:
(i) Rate of return on- (a) total shareholders’ equity and (b) equity of ordinary shareholders;
(ii) earnings per share;
(iii)dividends per share;
(iv) dividend–pay-out ratio;
(v) dividend and earnings yield; and
(vi) price-earnings ratio.
o Return on Total Shareholders’ Equity :
According to this ratio, profitability is measured by dividing the net profits after taxes (but
before preference dividend) by the average total shareholders’ equity. The term
shareholders’ equity includes (i) preference share capital; (ii) ordinary shareholders’
equity consisting of (a) equity share capital, (b) share premium, and (c) reserves and surplus
less accumulated losses. The ordinary shareholders’ equity is also referred to as net worth.
Thus,

𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝒕𝒂𝒙𝒆𝒔

Return on total shareholders' equity= X 100
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐭𝐨𝐭𝐚𝐥 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝒆𝒒𝒖𝒊𝒕𝒚

The ratio reveals how profitably the owners’ funds have been utilised by the firm. A
comparison of this ratio with that of similar firms as also with the industry average will
throw light on the relative performance and strength of the firm.
o Return on Ordinary Shareholders’ Equity (Net Worth):
While there is no doubt that the preference shareholders are also owners of a firm, the real
owners are the ordinary shareholders who bear all the risk, participate in management and are
entitled to all the profits remaining after all outside claims including preference dividends are
met in full. The profitability of a firm from the owners’ point of view should, therefore, in the
fitness of things be assessed in terms of the return to the ordinary shareholders. Thus,

𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝒕𝒂𝒙𝒆𝒔−𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝

Return on equity funds = X 100
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐭𝐨𝐭𝐚𝐥 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝒆𝒒𝒖𝒊𝒕𝒚

This is probably the single most important ratio to judge whether the firm has earned a
satisfactory return for its equity-holders or not. Its adequacy can be judged by-
(i) comparing it with the past record of the same firm
(ii) inter-firm comparison
(iii) comparisons with the overall industry average.
o Earning Per Share (EPS):
• EPS measures the profit available to the equity shareholders on a per share basis. The profits
available to the ordinary shareholders are represented by net profits after taxes and preference
dividend. Thus,
Net profit available to equity holders
EPS =
Number of ordinary shares outstanding

o Price Earning (P/E) Ratio:

• The P/E ratio reflects the price currently being paid by the market for each rupee of currently
reported EPS.
Market price of share
P/E ratio =
EPS
o Dividend Per Share (DPS):
• DPS is the net distributed profit belonging to the ordinary shareholders divided by the number of ordinary
shares outstanding.
Dividend paid to ordinary shareholders
DPS=
Number of ordinary shares outstanding

o Dividend Payout (D/P) Ratio:

• D/P Ratio also known as pay-out ratio measures the relationship between the earnings belonging
to the ordinary shareholders and the dividend paid to them. It can be calculated as-
Total dividend (cash dividend) to equityholders
D/P ratio = X 100
Total net profit belonging to equityholders

Dividend per ordinary share (DPS)

D/P = 𝑋 100
Earnings per share (EPS)
• If the D/P ratio is subtracted from 100, retention ratio is obtained. The ratio indicates what
percentage share of the net profits are retained in the business.
o Book Value Per Share:
• Book Value Per Share represents the equity/claim of the equity shareholder on a per
share basis. It is computed dividing net worth (equity share capital + reserves and
surplus – accumulated losses) by the number of equity shares outstanding (at balance
sheet date). Thus,
Net worth
Book value per share =
Number of ordinary shares outstanding
• However, the book value per share has a serious limitation as a valuation tool as it is
based on the historical costs of the assets of a firm. There may be a significant
difference between the market value of assets from the book value of assets (as per
balance sheet)
o Price To Book Value (P/B) Ratio:
• Price-to-Book Value Ratio measures the relationship between the market price of an equity share (MPS)
with book value per share (BPS. Thus,
MPS
P/B ratio =
BPS
The P/B ratio is significant in predicting future stock returns. Firms with low P/B ratios had consistently
higher returns compared to the firms with high P/B ratios.

o Cash Earnings Per Share:

• Cash Earnings Per Share is computed using cash flows from business operations as the numerator. This
value is determined by adding non-cash expenses, such as depreciation and amortization to net profits
available to equity owners. Thus,
Net profit available to equity + Depreciation + Amortisation + Non−cash expenses
Cash EPS=
Number of ordinary shares outstanding
• The ratio indicates the cash generating ability (per equity share) of the firm.
o Earnings and Dividend Yield:
• The earnings yield may be defined as the ratio of earnings per share to the market value per
ordinary share. Similarly, the dividend yield is computed by dividing the cash dividends per
share by the market value per share.
EPS
Earnings yield = X100
Market value per share

DPS
Dividend yield = X100
Market value per share

• The earnings yield is also called the earning-price ratio.

 NUMERICAL PROBLEM
INCOME STATEMENT RETAINED EARNINGS STATEMENT

Revenue 85000 Beginning retained 12000

earnings

Cost of goods sold 55000 Net income 20000

Salaries and wage 10000 Dividends 5000

expense
Net income 20000 Ending retained 27000
earnings

Given above is the income statement of company A with 100 outstanding shares each of
market price Rs.500. calculating the EPS, DPS, D/P ratio ,P/E ratio.
 SOLUTION
Ratio Formula Calculation Result
EPS Net profit available 20000/100 200
to equity
holders(net
income)/
Number of ordinary
shares outstanding

DPS Dividend payed to 5000/100 50

ordinary share
holders/Number of
ordinary shares
outstanding
D/P ratio (DPS/EPS)X100 (50/200)X100 25%
P/E Market price of 500/200 2.5
share /EPS
Earnings yield (EPS/market value (200/500)X100 40%
per share)X100
Dividend yield (DPS/market value (50/500)X100 10%
per share)X 100
ACTIVITY RATIOS/EFFICIENCY
RATIOS
 WHAT ARE ACTIVITY RATIOS?
• They measure the speed with which various assets are converted into sales or cash.
They measure efficiency in assets and hence also known as asset utilization ratios.
• The greater the rate of turnover or conversion, more efficient is the utilization of
assets, other things being equal. Hence, they are designated as turnover ratios.
• Turnover is the primary mode for measuring how efficiently firms are employing
assets. They are based on the relationship between level of activity represented by
sales and the levels of various assets.
• Depending on types of assets, we have different activity ratios:
 INVENTORY (OR STOCK) TURNOVER RATIO
• It measures the number of times inventory is replaced during the year. So, it shows
activity/liquidity of inventory. It is a test of efficient inventory management. High ratio
signifies good management. Thus,
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝒔𝒐𝒍𝒅
Inventory Turnover =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
• The monthly average can be found by adding opening inventory of each month. This method
has the advantage of being free from bias as it smoothens out fluctuations in inventory
levels. However, collecting month wise details maybe problematic for an analyst. So, we can
go for a second method:
𝑺𝒂𝒍𝒆𝒔
Inventory Turnover =
𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
• However, it again posits two disadvantages. Firstly, sales is expressed in terms of market
price and inventory in terms of cost. Hence, they are strictly incomparable. Also, closing
inventory are underestimates as firms are likely to have lower inventory at the end of the
year. Hence, it has a built-in bias that shows greater turnover.
Very high ratio: A very high ratio signifies underinvestment in inventory. This will adversely affect
the ability to meet consumer demand. So, the firm will be in danger of being ‘out of stock’, and incur
high ‘stock out cost’. Besides being costly, it may retard production process.
Very low ratio: This indicates excessive investment in inventory. This requires cost in terms of interest
on funds locked up, rental of space, possible deterioration and so on. It may be due to low quality
goods, overvaluation of closing inventory, stock of obsolete goods, and high purchase of goods in
anticipation of a future price rise.
Hence, firms should maintain a close watch on trend of ratio.
Some other turnover ratios:
Cost of raw materials used
Raw materials turnover =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 raw material inventory
Cost of goods manufactured
Work-in-progress turnover =
Average work−in−progress inventory
 DEBTOR’S OR RECEIVABLES TURNOVER
RATIO AND AVERAGE COLLECTION PERIOD
It shows how quickly debtors or receivables are converted into cash. Hence, it is a test of liquidity of
debtors. It shows the relationship between credit sales and debtors of a firm.
𝐂𝐫𝐞𝐝𝐢𝐭 𝒔𝒂𝒍𝒆𝒔
1. Debtor turnover =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬+𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐛𝐢𝐥𝐥𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞

Bills Receivable: Amount due to businesses for goods and services provided.
All the information required in this formula may not be readily available to the analyst and pose practical
difficulties.

Alternatively, we can calculate debtor’s turnover in terms of relationship between total sales and closing
balance of debtors:
𝐓𝐨𝐭𝐚𝐥 𝑺𝒂𝒍𝒆𝒔
2. Debtors turnover =
𝐃𝐞𝐛𝐭𝐨𝐫𝐬+𝐁𝐢𝐥𝐥𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞
This approach inflates the ratio and deflates the collection period.
Average Collection Period: It is the average amount of time needed to collect accounts receivable.
 𝐌𝐨𝐧𝐭𝐡𝐬 𝒅𝒂𝒚𝒔 𝐢𝐧 𝐚 𝒚𝒆𝒂𝒓
Therefore, Average Collection Period =
𝐃𝐞𝐛𝐭𝐨𝐫𝐬 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓

𝐌𝐨𝐧𝐭𝐡𝐬 𝒅𝒂𝒚𝒔 𝐢𝐧 𝐚 𝐲𝐞𝐚𝐫(𝐱)(𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬+𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐁𝐢𝐥𝐥𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞)

Alternatively, =
𝐓𝐨𝐭𝐚𝐥 𝐂𝐫𝐞𝐝𝐢𝐭 𝑺𝒂𝒍𝒆𝒔

Higher the turnover ratio and shorter the average collection period, better is the trade credit
management and better the quality of debtors as it signifies prompt payment by debtors.
A long collection period either implies poor credit collection or inadequate collection effort,
affecting liquidity position of a firm. Also, there is a likelihood of a large number of accounts
receivable becoming bad debts. Again, too short a collection period may confine sales to
customers making prompt payments. Without reasonable credit, sales would be severely curtailed.
Hence, a reasonable collection period should be maintained.
 EXAMPLE

The credit sales of a firm in a year = Rs. 12,00,000. The outstanding amount to
debtors at the beginning and end of the year are Rs. 1,40,000 and Rs. 1,60,000
respectively.

𝐑𝐬.𝟏𝟐,𝟎𝟎,𝟎𝟎𝟎
Debtor Turnover Ratio = = 8(times per year)
(𝐑𝐬 𝟏,𝟒𝟎,𝟎𝟎𝟎+𝐑𝐬 𝟏,𝟔𝟎,𝟎𝟎𝟎)/𝟐
This means debtors get converted into cash 8 times a year.
𝟏𝟐 𝒎𝒐𝒏𝒕𝒉𝒔
Average debt collection period = = 1.5 months or 45 days
𝟖
This means debtors on an average are collected in 45 days.
 ASSETS TURNOVER RATIO/
INVESTMENT TURNOVER RATIO
It measures the efficiency of a firm in managing and utilizing its assets. It shows the relationship between cost of goods sold
and assets of a firm. Depending on different concepts of assets employed, we get the following ratios:
Cost of goods sold
1. Total Assets Turnover =
Average total assets
Cost of goods sold
2. Fixed Assets Turnover = Average fixed assets
Cost of goods sold
3. Capital Turnover = Average capital employed
Cost of goods sold
4. Current Assets Turnover = Average current assets
Cost of goods sold
5. Working Capital Turnover = Net working capital

Higher the turnover ratio, more efficient is the management of assets, while low turnover ratios are indicative of
underutilization of available resources and presence of idle capacity. So, it can expand production without additional capital
investments.
The total and fixed assets are net of depreciation. Hence, these ratios are likely to be higher in case of old and established
companies compared to new ones.
GROWTH RATIOS
 WHAT ARE GROWTH RATIOS?
• Growth ratios measure the rate at which a firm should grow.
• Growth in sales needs additional investment to support incremental sales both in
terms of current assets (such as inventory and debtors) and productive
capacity/long- term assets (such as plant and machinery). The rate at which a
firm can grow depends on factors such as – investment in assets required for a
given growth rate, net profit margin, retention ratio, and willingness and ability
to raise finances from the financial markets.
• The firm’s growth rate is higher when external finances are used. It is lower
when it uses internally generated funds (retained earnings) only to finance its
assets.
• Accordingly, there are two types of growth rates:
1) Internal Growth Rate (IGR)
2) Sustainable Growth Rate (SGR)
 INTERNAL GROWTH RATE (IGR)
The IGR is the maximum rate at which a firm can grow (in terms of sales or assets)
without external financing of any kind. To determine the IGR the following assumptions
are made:
i. There is an increase in assets of the firm in proportion to the sales
ii. The net profit margin after taxes (EAT) is in direct proportion to sales.
iii. The firm has a target dividend payout ratio (retention ratio) which it wants to maintain
iv. The firm wants to grow at a rate which is warranted by its retentions. In other words,
the firm does not raise external funds (neither equity nor debt) to finance assets.
IGR is provided by,
𝑅𝑂𝐴×𝑏
𝐼𝐺𝑅 =
1− 𝑅𝑂𝐴×𝑏
Where, 𝑅𝑂𝐴 is the return on assets (measured by EAT/total assets) and 𝑏 is retention ratio
(1 - dividend payment ratio).
 BEFORE GROWTH
Financial statements of Hypothetical Ltd and its
IGR
i. Income statement (Amount in Rs lakh)
Sales revenue 200
Less: costs (70% of sales) 140
Earnings before taxes (EBT) 60
Less: taxes (35%) 21
Earnings/profits after taxes (EAT) 39
Dividend payout ratio 𝑬𝑨𝑻 × 𝟏Τ𝟑 13
Retained earnings 𝑬𝑨𝑻 × 𝟐Τ𝟑 26

i. Balance sheet
Total assets 200
Total liabilities
Equity 150
𝑅𝑂𝐴×𝑏 Total debt 50
iii. 𝐼𝐺𝑅 = 1− 𝑅𝑂𝐴×𝑏
𝐸𝐴𝑇 39
Here, ROA% = Total assets × 100% = 200 × 100% = 19.50%
And 𝑏 = 2Τ3
19.50% ×2Τ
Therefore, 𝐼𝐺𝑅 = 1− 19.50% ×23Τ = 14.94
3
Thus, the Hypothetical Ltd can grow at a maximum rate of 14.94% per year with no external financing.
 AFTER GROWTH
Financial statements of Hypothetical Ltd (After
growth)
i. Income statement (Amount in Rs lakh)
Sales revenue [200*(1+0.1494)] 229.88
Less: costs (70% of sales) 160.92
Earnings before taxes (EBT) 68.96
Less: taxes (35%) 24.14
Earnings/profits after taxes (EAT) 44.82
Dividend payout ratio 𝐄𝐀𝐓 × 𝟏Τ𝟑 14.94
Retained earnings 𝐄𝐀𝐓 × 𝟐Τ𝟑 29.88

i. Balance sheet
Total assets 229.88
Equity 179.88
Total debt 50
Total liabilities 229.88

𝐸𝐴𝑇 44.82
Return on assets (ROA) = × 100% = × 100% = 19.50%
Total assets 229.88
 SUSTAINABLE GROWTH RATIO (SGR)
SGR is the maximum rate at which the firm can grow by using internal sources (retained earnings) as well as
additional external debt but without increasing its financial leverage (debt-equity ratio). To determine SGR, two
additional assumptions are made:
i. The firm has a target capital structure (D/E ratio) which it wants to maintain
ii. The firm does not intend to sell new equity shares as it is a costly source of finance.
SGR is provided by,
𝑅𝑂𝐸 × 𝑏
𝑆𝐺𝑅 =
1 − 𝑅𝑂𝐸 × 𝑏
Where, 𝑅𝑂𝐸 is the product of net profit margin (P), assets turnover (A) and financial leverage (A/E) ratios.
Accordingly, SGR can be decomposed as,
𝑃 × 𝐴 × 𝐴/𝐸 × 𝑏
𝑆𝐺𝑅 =
1 − 𝑃 × 𝐴 × 𝐴/𝐸 × 𝑏
Therefore, SGR of the firm can be increased by any one or more of the following four factors:
i. Increase in the net profit margin(P)
ii. Increase in the asset turnover ratio(A)
iii. Increase in the financial leverage (A/E)
iv. Increase in the retention ratio (or decrease in dividend payout ratio) or issue of new equity shares.
 Determination of SCR of Hypothetical
Ltd
(Amount in Rs lakh)
𝐏 = 𝐄𝐀𝐓Τ𝐒𝐑 = 𝟑𝟗Τ𝟐𝟎𝟎 ∗ 𝟏𝟎𝟎% 19.50
𝐀 = 𝐒𝐚𝐥𝐞𝐬Τ𝐀𝐬𝐬𝐞𝐭𝐬 = 𝟐𝟎𝟎Τ𝟐𝟎𝟎 𝐭𝐢𝐦𝐞𝐬 1
𝐀Τ𝐄 = 𝐀𝐬𝐬𝐞𝐭𝐬Τ𝐨𝐰𝐧𝐞𝐫 ′ 𝐬 𝐞𝐪𝐮𝐢𝐭𝐲 4/3
= 𝟐𝟎𝟎Τ𝟏𝟓𝟎 𝐭𝐢𝐦𝐞𝐬

b = retention ratio 2/3

4
Here, ROE (%) =0.195 × 1 × = 26%
3
𝑃×𝐴×𝐴/𝐸×𝑏 0.195×1×4/3×2/3 0.1733
𝑆𝐺𝑅 = = 4 2 = = 20.97
1− 𝑃×𝐴×𝐴/𝐸×𝑏 1−(0.195×1× × ) 0.8267
3 3

Thus, the Hypothetical Ltd can grow at a maximum rate of 20.97% per year without external
equity financing and maintaining existing ROE.
 AFTER GROWTH
Financial statements of Hypothetical Ltd
(After growth)
i. Income statement (Amount in Rs lakh)
Sales revenue [200*(1+0.2097)] 241.94
Less: costs (70% of sales) 169.36
Earnings before taxes (EBT) 72.58
Less: taxes (35%) 25.40
Earnings/profits after taxes (EAT) 47.18
Dividend payout ratio 𝐄𝐀𝐓 × 𝟏Τ𝟑 15.73
Retained earnings 𝐄𝐀𝐓 × 𝟐Τ𝟑 31.45

i. Balance sheet
Total assets 241.94
Equity (initial equity + retained earnings) 181.45
Total debt (total assets – equity) 60.49
Total liabilities 241.94

𝐸𝐴𝑇 47.18
Return on equity (ROE) = equity × 100% = 181.45 × 100% = 26%

From the above, it can be deduced that when a company grows at a rate higher than its SGR, it has better operating
performance (reflected in the higher net profit margin or the asset turnover ratio) or it is prepared to revise its financing
policies (represented by increasing its profit retention ratio or its debt-equity financial leverage ratio). In case, the firm
anticipates that it is neither possible to improve operating performance nor it is willing to assume more risk by higher D/E
ratio, it should prefer to grow at the SGR or at a lower rate to conserve financial resources to avoid problems of liquidity and
solvency in future.
INTEGRATED ANALYSIS OF
RATIO
Integrated Analysis of Ratio is a financial ratio which measures the relationship among
these ratios- liquidity ratios, efficiency ratios, profitability ratio.
These disaggregation reveals certain major economic and financial aspect such as the significant
changes in profitability measures in terms of Return on Asset (ROA) and Return on Equity
(ROE).

➢RETURN ON ASSET (ROA):

Profitability ratio focusses on two aspects of profitability of a firm
1. Owners of the firm-in terms of the ratios covered under rate of return to equity holders
2. Operating Efficiency of Firm- in terms of efficient resource utilisation reflected through net
profit margin

The overall profitability is termed as Earning power / Return on Asset (ROA) Ratio. Earning
power is defined as the overall profitability of enterprise.
ROA ratio is the central measure of measuring the overall profitability and overall efficiency of a firm. It
shows the interaction between profitability and activity ratio. This ratio implies that performance of a firm
can be improved by generating more sales or by increasing profit margin
Overall profitability of enterprise has two elements
1. Profitability on Sales- reflected in net profit margin
2. Profitability off Asset- revealed by the asset or investment turnover

Earning Power (ROA ratio) = Net Profit Margin × Asset Turnover

Where Net Profit Margin is the earning after tax or sales and Asset Turnover is the total sales
Therefore,
𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑺𝒂𝒍𝒆𝒔 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
Earning Power= × =
𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕

Basic element of Earning Power is reflected through Du Pont Chart.

 𝑵𝑬𝑻 𝑷𝑹𝑶𝑭𝑰𝑻
ROA (RETURN ON ASSET) = defined as a product of
𝑻𝑶𝑻𝑨𝑳 𝑨𝑺𝑺𝑬𝑻

𝑵𝑬𝑻 𝑷𝑹𝑶𝑭𝑰𝑻
NPM (NET PROFIT MARGIN) = and
𝑵𝑬𝑻 𝑺𝑨𝑳𝑬𝑺

𝑵𝑬𝑻 𝑺𝑨𝑳𝑬𝑺
TATR (TOTAL ASSET TURNOVER RATIO) =
𝑻𝑶𝑻𝑨𝑳 𝑨𝑺𝑺𝑬𝑻

This decomposition shows how return on Total Asset is influenced by net profit margin and total
asset turnover ratio.

The upper side of the chart shows the details underlying net profit margin ratios which indicates
the areas of cost reduction so as to improve profit margin.

The lower side tells us about the determinants of total asset turnover ratio.
 NUMERICAL EXAMPLE
Suppose there are two firms A & B each having total asset amounting to Rs. 4 lacs and average net profit
after paying tax of 10% i.e., Rs. 40,000 each. Firm A has a sale of Rs. 4 lac whereas the sales pf Firm B is
Rs.40 lac. Determine the ROA.
SL.N PARTICULARS FIRM A FIRM B
• SOLUTION: O
1 NET SALES 4,00,000 40,00,000
2 NET PROFIT 40,000 40,000
3 TOTAL ASSETS 4,00,000 4,00,000
4 PROFIT MARGIN (2/1) (per cent) 10 1
5 ASSET TURNOVER (1/3) 1 10
6 ROA RATIO (4*5) 10 10

NOTE: The usefulness of the integrated analysis is that it presents the overall picture of the firm’s
performance also enables the management to identify the factors which have a bearing on profitability.
 RETURN OF EQUITY RATIO
Profitability analysis bases on ROA is now extended to Return on Equity (ROE). Return on Equity (ROE this is one
of the most important in terms of financial performance from the view of equity holders.
ROE is decomposed into three components:
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑺𝒂𝒍𝒆𝒔 𝑨𝒔𝒔𝒆𝒕𝒔
𝐑𝐎𝐄 = × ×
𝑺𝒂𝒍𝒆𝒔 𝑨𝒔𝒔𝒆𝒕𝒔 𝑬𝒒𝒖𝒊𝒕𝒚
These three components are indicative of :
1. profitability through Net profit margin
2. Efficiency in operation through asset turnover
3. Financial leverage indicating the extent to which assets are financed by owner firms
Thus, ROE is the combination of three ratios:
ROE= Net profit ratio × Asset turnover × Financial Leverage
The above equation tells that the management of a firm controls ROE through :
1. Net profit margin per rupee of sales.
2. Sales granted per rupee of asset employed
3. Amount of equity used to finance assets
Profit margin summarizes profit performance as reflected in the income statement of a firm on the other hand asset turnover
and financial leverage measures performance w.r.t asset and liability side of balance sheet. The financial performance of firms
is captured by these three elements.
• EXAMPLE:
Suppose there are two firms A & B each having total asset amounting to Rs. 4 lacs and average net profit after paying tax of
10% is Rs. 40,000 each. Firm A has a sale of Rs. 4 lac whereas the sales pf Firm B is Rs.40 lac. Firm A uses equity capital of
Rs. 2 lakh and Firm B of Rs. 2.5 lakhs in financing total assets of Rs. 4 lacs. Calculate ROE.
• SOLUTION:
SL.N PARTICULARS FIRM A FIRM B
O
1 NET SALES 4,00,000 40,00,000
2 NET PROFIT 40,000 40,000
3 TOATAL ASSETS 4,00,000 4,00,000
4 EQUITY CAPITAL 2,00,000 2,50,000
5 TOTAL ASSETS 4,00,000 4,00,000
6 FINANCIAL LEVERAGE (5/4) 2 1.6
7 PROFIT MARGIN (2/1) (per cent) 10 1
8 ASSET TURNOVER (1/3) 1 10
9 ROE RATIO (6×7×8) (per cent) 20 16
 DUPONT ANALYSIS ON ROE RATIO
DuPont analysis is a useful technique used to decompose the different drivers of Return on Equity(ROE). The
decomposition of ROE allows investors to focus on the key metrics of financial performance individually to
identify strengths and weaknesses. The DuPont analysis is a formula used to track a company's financial
performance. A DuPont analysis is used to evaluate the component parts of a company's ROE. This allows an
investor to determine what financial activities contribute the most to the changes in ROE.
Three components of ROE represented by the equation
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑺𝒂𝒍𝒆𝒔 𝑨𝒔𝒔𝒆𝒕𝒔
ROE= × ×
𝑺𝒂𝒍𝒆𝒔 𝑨𝒔𝒔𝒆𝒕𝒔 𝑬𝒒𝒖𝒊𝒕𝒚

This can be expanded further to consider the effect of interest and tax payment. Net Profit Ratio is
disaggregated and the asset turnover and financial ratios remains unchanged.
This is represented by the formula:
𝑬𝑨𝑻 𝑬𝑩𝑻 𝑬𝑩𝑰𝑻 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕
× × =
𝑬𝑩𝑻 𝑬𝑩𝑰𝑻 𝑺𝒂𝒍𝒆𝒔 𝑺𝒂𝒍𝒆𝒔
Where
• EAT= EARNINGS AFTER TAX
• EBIT= EARNINGS BEFORE INTERSTS AND TAXES
• EBT= EARNINGS BEFORE TAX
These five way break up of ROE enables the management of a firm to analyse the effect of interest
payment and tax payment separately from operating Profitability.
THERE EXISTS A Relationship between ROA and ROE

1. ROE and ROA are the two key measures to determine how efficient a company is at
generating profits.

2. The main difference between the two is that ROA takes into account leverage/debt while
ROE doesn’t.

3. ROE can be calculated by multiplying ROA by equity multiplier which is given by the
equation

ROE= (ROA- Interest Cost ÷ Assets) × Assets ÷ Equity

 CONCLUSION
Ratios are a powerful tool in the interpretation of the accounts and can discover issues
and problems, not immediately evident from the accounts and financial information
provided in the annual report. They can provide the basis for inter-firm comparisons
allowing managers to benchmark the performance and efficiency of the firm against its
competitors. Trends can then be examined and analyzed. Stakeholders may use ratios
to support their decision making. Employees, for example may use profit ratios to
support pay claims and creditors can use liquidity ratios to evaluate whether debts will
be repaid.
THANK YOU