FINANCIAL RATIOS

Table of Contents
PROFITABILITY RATIOS .................................................................................................................................. 2
Profit Margins ........................................................................................................................................... 2
Return on Assets ....................................................................................................................................... 2
Return on Capital Employed ..................................................................................................................... 2
Return on Invested Capital ....................................................................................................................... 2
Return on Equity ....................................................................................................................................... 3
TURNOVER RATIOS ....................................................................................................................................... 4
Asset Turnover Ratio ................................................................................................................................. 4
Cash Conversion Cycle and Operational Turnover Ratios: ....................................................................... 4
MARKET AND VALUATION RATIOS ............................................................................................................... 6
EPS:............................................................................................................................................................ 6
Dividend Payout Ratio and Retention Ratio: ............................................................................................ 6
Price to Equity Ratio.................................................................................................................................. 6
PEG Ratio................................................................................................................................................... 6
Price/Book Value Ratio ............................................................................................................................. 7
EV/EBITDA ................................................................................................................................................. 7
Other Industry Specific Ratios:.................................................................................................................. 7
Dividend Yield ........................................................................................................................................... 7
LIQUIDITY RATIOS ......................................................................................................................................... 9
Current Ratio ............................................................................................................................................. 9
Quick Ratio or acid ratio ........................................................................................................................... 9
Cash Ratio ................................................................................................................................................. 9
DEBT RATIOS ............................................................................................................................................... 10
Interest Coverage Ratio: ......................................................................................................................... 11
A Few basic things

One ratio cannot be used for the analysis of the whole company and several of them
have to be looked at simultaneously to form the whole picture
The ratios vary vastly across different industries and thus they must be compared to
their peer companies to get a fair idea about the companies performance

PROFITABILITY RATIOS
Profit Margins
Margins are the profit metric used as a percentage of the total sales. Thus

Margin = Profit Metric / Total Sales Formatted: Font: Not Bold, Italic

The Profit metric used could be Gross Profit, EBITDA, EBIT, PBT or PAT, and the margin is called the
metric followed by the word Margin, for example EBIT Margin or PAT Margin.

Comparing the margins for competitors could give an idea of the relative performance of companies and
the differences in margins for a company are used to analyze how much money is spent at what stage of
the business.

Return on Assets
ROA = EBIT / Total Assets Formatted: Font: Not Bold, Italic
EBIT is independent of the companys Capital Structure (Whether it has been financed by Equity
or Debt) and the assets are employed for generation of EBIT, irrespective of whether they were
financed through debt or equity. Thus ROA is a measure of how efficiently the company
manages its assets.

Return on Capital Employed

ROCE = EBIT/ Working capital employed Formatted: Font: Not Bold, Italic
Where working capital = Total Assets Current Liabilities
Capital Employed may also be seen Equity + Non Current Liability or as the total money the
company has raised through financing.

Although they both convey similar information, ROCE is from the liability perspective as to how
much return a company gives per the amount of capital raised, whereas ROA is from the asset
perspective as to how well the company is using its assets.

Return on Invested Capital

ROIC = EBIT/ Invested Capital Formatted: Font: Not Bold, Italic
where Invested Capital is Capital Employed Cash and Cash equivalents.
This is a further refinement of ROCE since the cash although is needed to buy things needed to Commented [YG1]: Assets?
generate profits, but in itself, sitting with the company as reserves, it isnt generating any
revenue or profit for the company, thus makes sense to be removed from the Emplyed Capital.

NOTE: NOPAT (Net operating profit after tax) is sometimes used for ROA, ROCE and ROIC
calculations to account for tax payable directly on the operating profit. But even here, interest
expense is not reduced because the denominator contains assets financed from both debt and
equity and thus portion of the income contributed towards debt holders (ie interest) should not
be removed.

Return on Equity
ROE = Net Income/Shareholders Equity Formatted: Font: Not Bold, Italic
ROE is a metric of how profitable it is to invest in the equity of a company.
Net income is used for ROE, because Net Income is the value that is given back to the
shareholders through dividends paid or the increase in shareholders equity through retained
earnings and the interest and tax paid is removed from ROE calculation as it belongs to the
lender and the government respectively.
To be noted that two companies with the exactly same assets and performance may have very
different ROE if they have different capital structures.
TURNOVER RATIOS

These usually imply how effectively you transform something that the business has to
something that the business generates from it, or a balance sheet item to a corresponding PnL
item that the balance sheet item is ultimately used for. Usually the Balance sheet items are the Commented [YG2]: Isko thoda simplify kar. Kaafi ajeeb
average of the opening and closing values for the period for which the PnL is being considered. sound kar raha hai.
Commented [YG3]: For which the P&L is being
Asset Turnover Ratio prepared/ considered.
In general the purpose of all the assets is to generate sales for the business. Thus

ATR = Sales/Assets Formatted: Font: Not Bold, Italic

NOTE: This has further application in the DuPont Analysis.

Cash Conversion Cycle and Operational Turnover Ratios:

A business usually has inventories so that they can be consumed to be sold off as the final product.
Therefore

Inventory Turnover Ratio = COGS / Inventory Formatted: Font: Not Bold, Italic

This can be interpreted as the number of times the average inventory has to be restocked for all the
production in the year. Hence

Days Inventory Outstanding = 365 / (Inventory Turnover Ratio) Formatted: Font: Not Bold, Italic

This can be interpreted as the number of days it takes from buying the raw material to selling the
produced goodsto consume the average stock of inventory or the days it holds on to an inventory before Formatted: Strikethrough
selling it. Thus a lower DIO indicates inventory efficiency of the company and is desirable. Formatted: Strikethrough
Commented [YG4]: So does this outstanding days start
Receivables turnover ratio
from the moment you purchase your raw material and ends
when you sell it.? Or from the moment your inventory is
Receivables are usually owed by the customers to the business, and are a part of the sales by the produced to the point of sale? You can add this explanation
company. here too.
Formatted: Strikethrough
Receivables turnover ratio = Sales/Receivables
Formatted: Font: Not Bold, Italic
InterpretationThis is mostly used in the form of DSO Commented [YG5]: The days sales outstanding gives a
better picture. Ratio ka interpretation mat daal. Same for
payables.

Days Sales Outstanding (DSO) = 365/ (Receivables turnover ratio) Formatted: Font: Not Bold, Italic

This is the number of days a company takes to collect revenue after a sale has been made. Due to the
high importance of cash in running a business, its best for the company to collect outstanding
receivables as quickly as possible and reinvest in the business, and thus a low DSO is desirable and a high
DSO could lead to cash flow problems for the company.
Trade Payables turnover ratio and DPO

Payables are usually to the suppliers of the business to purchase the raw material and other things.

Trade Payables Turnover Ratio = Purchases / Payables Formatted: Font: Not Bold, Italic

This can be interpreted as the ________This is mostly used in the form of DPO

Days Payables Outstanding (DPO) = 365 / (Trade Payables turnover ratio) Formatted: Font: Not Bold, Italic

This is the number of days the company on an average takes to pay its suppliers. A high DPO could
imply that the suppliers have trust in the company are willing to give it supplies on credit. Another way
to look at it could be that the company is having trouble paying its suppliers and is taking very long.

Cash Conversion Cycle

Usually a company acquires inventory on credit, which results in accounts payable. A company can also
sell products on credit, which results in accounts receivable. Cash, therefore, is not involved until the
company pays the accounts payable and collects the accounts receivable. So the cash conversion cycle
measures the time between the outlay of cash and the cash recovery and measures the number of days
each net input dollar is tied up in the production and sales process before it is converted into cash.

Its formula is given by

CCC = DIO + DSO DPO Formatted: Font: Not Bold, Italic

CCC is not looked usually at a standalone basis and it is seen as a pattern over the years or
with respect to its competitors, along with other ratios. But typically, a lower CCC is considered
healthier for a company and a higher CCC could indicate cash flow problems.

-ve Cash Flow:<interpretation> A negative cash flow basically means that the company has higher powers to Commented [YG6]: A negative cash flow basically means
dictate terms. This could be due to the large size of the company in the market or the company could be the only that the company has higher powers to dictate terms. This
monopoly player. Taking a large fmcg as eg, (ITC) can have a -ve cash flow since it can demand a higher credit could be due to the large size of the company in the market
period from its suppliers and in turn give lower credit to the customers. Also some industries like the e-commerce or the company could be the only monopoly player. Taking a
large fmcg as eg, (ITC) can have a -ve cash flow since it can
demand a higher credit period from its suppliers and in turn
give lower credit to the customers.

This is also known as the Operating Cycle.

MARKET AND VALUATION RATIOS

EPS:
Basically the amount of net income that each shareholder is entitled to
EPS = Net Income / #Shares Formatted: Font: Not Bold, Italic
NOTE: Unlike several of the Market Ratios, EPS is independent of the market price of the share and not
to be confused with the dividends paid.

Dividend Payout Ratio and Retention Ratio:

The net income generated by a company can be utilized for 2 purposes. To pay cash rewards to the
shareholders or to invest back and grow the business. The portions of the Net Income given to these 2
purposes are the Dividend Payout Ratio and Retention Ratio respectively. Thus
Dividend Payout Ratio = Total Dividends Paid/Net Income Formatted: Font: Not Bold, Italic
Retention Ratio = (Net Income Total Dividends Paid)/Net Income Formatted: Indent: First line: 0.5"
Note: Total Dividends Paid = Dividend given per share * #Shares, but given the financials of the
company, you can calculate the Total Dividends Paid by checking what part of the net income has
not been added to the retained earnings, ie Net Income (Increase in the Retained Earnings from
opening to closing)

Price to Equity Ratio

Often called the PE ratio, its formula is as its name suggests
PE Ratio = Price per share/EPS
The EPS taken is usally for the past year or TTM (Trailing Twelve Months)
This is the price you pay to earn a dollar of earnings from the share. So, normally youd prefer a
lower PE, but this is a very nave evaluation and there are several things to be considered while
evaluating a share. Different industries have very different ranges of PE ratios and even within an
industry, the capital structure adversely changes the PE ratio. <Fill in other ways a PE ratio may be
very different>
Note: For a better understanding of how Capital Structure changes the PE ratio watch:
https://www.khanacademy.org/economics-finance-domain/core-finance/stock-and-
bonds/valuation-and-investing/v/p-e-conundrum

PEG Ratio
Price/Earnings-to-growth ratio considers the estimated growth of the company of the company.
The earnings in PE ratio are historical, but for PEG ratio, we consider the future estimates of
earnings for the coming year, thus the denominator is estimated EPS or TTM EPS * growth estimate.
PEG Ratio = Share Price / (EPS * Growth) Formatted: Font: Not Bold
This could give a better picture to compare 2 shares for investing purposes. Formatted: Indent: First line: 0.5"
Formatted: No underline
Price/Book Value Ratio
The Book Value of the equity is its value that is mentioned in the Balance Sheet, which can also be
calculated as the difference of the total assets and the liabilities. The Price part denotes what the market
values this equity as or the market capitalization. Thus

P/B ratio = (Market Capitalization/Book Value of Equity) OR (Share Price/Book Value per share) Formatted: Font: Italic
Where where Market Capitalization = Share Price * #Shares Formatted: Font: Not Bold, Italic

NOTE: The exact value of the liabilities is very objective, but the assets exact value is subjective which is Formatted: Font: Italic
valued by the market by changing the share price, since Formatted: Indent: Left: 0.5"
Market Value of Assets = Share Price * #Shares + Liabilities
The P/B ratio is preferred rather than PE ratio in certain industries like banking because banking
business is dependent more on the market evaluation of the balance sheet rather than the book values
or in the IT or other industries where there is a significant amount of intangible assets which cannot be
included in the balance sheets.

EV/EBITDA
One major drawback of the PE ratio is its dependence on the capital structure of the firm, for which
EV/EBITDA is a better measure. EBITDA is used instead of EBIT as the depreciation method adopted
by different companies could be different thus EBITDA is used as a more universal for the proxy for
the operating profit. Being a market valuation ratio, the asset value corresponding to the operating
profit has to what the market evaluates the companys operating assets value to be. Thus
Enterprise Value is defined as the market value of operating assets
Enterprise Value = Market Value of Equity + Market Value of Liabilities Cash Reserves Formatted: Font: Not Bold, Italic
= Market Capitalization + Total Liabilities Cash Commented [YG7]: An expanded version could be that
Cash is excluded from the enterprise value as cash in itself does not lead to any generation of you also reduce the minorities interest from this.
EBITDA and its only when you buy other assets from the cash that the generate profits. Formatted: Font: Italic
Thus the ratio is given by
Formatted: Font: Not Bold, Italic
EV/EBITDA = Enterprise Value/ EBITDA
The main advantage of this ratio over PE ratio is its indifference frominherent incorporation of the
capital structure. Commented [YG8]: Incorporation of the capital structure

Other Industry Specific Ratios:

Various other ratios are used for specific industries for example Price/Sales for retail industry or

Dividend Yield
A financial ratio that indicates how much a company pays out in dividends each year relative to its share
price. It is somewhat a measure of bang for your buck.
Dividend Yield = Annual Dividend per Share/Share Price
Yields for a current year are often estimated using the previous years dividend yield or by taking the
latest quarterly yield, multiplying by 4 (adjusting for seasonality) and dividing by the current share price.
LIQUIDITY RATIOS
Liquidity has to do with a firm's assets and liabilities. In particular, liquidity looks at whether or not a
firm can pay its current liabilities with its current assets.

Following are the list of liquidity ratios -

Current Ratio
The current ratio shows how many times over the firm can pay its current debt obligations based on its
current assets. In general, current assets implies assets which will be utilized and hence generate cash in
1 year and current liabilities implies liabilities that need to be paid within 1 year that is cash will be
utilized. So, this ratio means how much current assets a firm has to meet its current liabilities.

Current Ratio = Current Assets/Current Liabilities Formatted: Font: Not Bold, Italic
Formatted: Indent: First line: 0.5"
Remarks - A current ratio of less than 1 indicates that the company may have problems meeting its
short-term obligations so a current ratio of more than 1 around 1.5-2.5 is safe. However, too high
current ratio is also not desirable because that would mean company is not using its current assets
efficiently For instance, current ratio for Apple was recently around 10 or 12 because they amassed a
hoard of cash. But investors get impatient, saying, We didnt buy your stock to let you tie up our
money. Give it back to us. And then they are in a position of paying dividends.

Quick Ratio or acid ratio

The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well the
company can meet its short-term debt obligations without having to sell any of its inventory to do so.

Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory.
Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to
meet their short-term debt obligations without having to rely on selling inventory.

Quick Ratio = Current Assets-Inventory/Current Liabilities Formatted: Font: Not Bold, Italic
Formatted: Indent: First line: 0.5"
Cash Ratio
The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the
quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current
assets to cover current liabilities. It only looks at the most liquid short-term assets of the company,
which are those that can be most easily used to pay off current obligations. It ignores inventory, prepaid
expenses and receivables as there are no assurances that these two accounts can be converted to cash
in a timely matter to meet current liabilities. So, difference between quick ratio and cash ratio is that
account receivables is not present in cash ratio unlike quick ratio.

Cash Ratio = (Cash + Cash Equivalents) / (Current Liabilities) Formatted: Font: Not Bold, Italic
Formatted: Indent: First line: 0.5"
Remarks - A cash ratio of 1.00 and above means that the business will be able to pay all its current
liabilities in immediate short term. Therefore, creditors usually prefer high cash ratio. But businesses
usually do not plan to keep their cash and cash equivalent at level with their current liabilities because
they can use a portion of idle cash to generate profits. This means that a normal value of cash ratio is
somewhere below 1.00. Also, it is not realistic for a company to purposefully maintain high levels of cash
assets to cover current liabilities. The reason being that it's often seen as poor asset utilization for a
company to hold large amounts of cash on its balance sheet, as this money could be returned to
shareholders or used elsewhere to generate higher returns.

DEBT RATIOS
These ratios aim to highlight the amount of debt taken by a firm. Having a higher debt doesnt
necessarily mean bad as long as the company is using that debt to expand or optimize its business
operations or make long term investment which will generate revenue or reduce cost for instance
purchase/replace equipment or buy land or buy plant.

In general, debt means long term borrowings and other non-current liabilities (not including provisions)

There are primarily 3 types of debt ratios:

Debt to Assets ratios: This is the simplest ratio to measure the amount of debt. It means what
percentage of assets are being funded by debt

Debt Ratio = Total Debt / Total Assets Formatted: Font: Not Bold, Italic
Formatted: Indent: First line: 0.5"
Generally, large well-established companies can push the liability component of their balance sheet
structure to higher percentages without getting into trouble.

Debt to Equity Ratio: It is another way of representing the capital structure of the firm. This is a
measurement of how much lenders, creditors and obligors have committed to the company versus
what the shareholders have committed.

Debt/Equity = Total Debt/Shareholders Equity Formatted: Font: Not Bold, Italic

Formatted: Indent: First line: 0.5"
In general, if your debt-to-equity ratio is too high, its a signal that your company may be in financial
distress and unable to pay your debtors. But if its too low, its a sign that your company is over-relying
on equity to finance your business, which can be costly and inefficient.

Remarks - The debt to equity ratio can be misleading at times. An example is when the equity of a
business contains a large proportion of preferred stock. In this case a dividend may be mandated in the
terms of the stock agreement. This in turn impacts the amount of available cash flow to pay debt. Then
the preferred stock has the characteristics of debt, rather than equity.

Financial Leverage: This is another way of type of debt ratio. It means how much assets is funded by
equity. Lower the leverage, the more is equity-funded asset.

Financial Leverage: Total Assets / Total Equity Formatted: Font: Not Bold, Italic
Formatted: Indent: Left: 0.5"
So, if the ratio is high it means less equity has been used to fund total assets. Business companies with
high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts,
it might lead to difficulties in getting new lenders in future.

Interest Coverage Ratio:

More the debt, higher will be the interest expense. That means the company has to have higher EBIT to
cover it. We take EBIT because it is the revenue just above interest.

ICR = EBIT(1-tax rate) / Interest Expense Formatted: Font: Not Bold, Italic
Formatted: Indent: First line: 0.5"
Tax Rate is optional as taking tax into account is a more conservative approach since tax will anyways
will be deducted so we remove the tax component before calculating ICR. However, it is not necessary
to remove tax but we have to consistent with the formula, however the above formula is preferred.

ICR = EBIT / Interest Expense Formatted: Font: Not Bold, Italic

Formatted: Indent: First line: 0.5"
Remarks: As a general rule of thumb, investors should not own a stock or bond that has an interest
coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having
difficulties generating the cash necessary to pay its interest obligations. If a company has high operating
leverage, and sales decline, it can have a shockingly disproportionate effect on the net income of the
firm. This would result in a sudden, and equally excessive, decline in the interest coverage ratio, which
should send up red flags for any conservative investor.