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Ratio Formula What the ratio Interpretation

analysis means Index


Name of the
ratio
Profitability
%
Gross Gross operating Indicates Gross Higher the ratio
Operating profit/Sales*100 surplus generated per better the
Margin rupee of sales after performance
meeting
manufacturing costs.
It measures the
efficiency between
production costs and
pricing.
Operating Operating Indicates the
profit margin profit/Sales*100 Operating costs i.e.
marketing and -Do-
Operating profit=Cost of administration costs is
goods sold + Operating under control which
expenses. will improve the
profitability of the
business
Net Profit EBIT (1-t)/Sales*100 Indicates management
margin efficiency in -do-
generating revenues
by minimizing cost
Cost of goods Cost of goods sold/Net The profitability of a Lesser the cost
sold/Net Sales business can be of goods on Sale,
Sales measured by better the
comparing Cost with profitability of
revenue the company.
Return on NPAT-preference Indicates the rate of
Net worth dividend/Networth *100 Profit earned for every Higher the ratio
rupee invested by the better the
owners performance
Return on EBIT*(1-t)/CE *100 Indicates the rate of
Capital return for every rupee -do-
Employed of resource invested
by the owners and the
Outsiders
Return on PAT/Total average It indicates how much
Assets assets returns the company -do-
has earned on every
Re.1 of asset that it
has.
Valuation
(x)
Earnings per NPAT-preference This shows profit Higher the ratio
share dividend/Number of earned per equity more productive
equity Shareholders share for the real the use of equity
owners of the share investment
company .EPS can be
increased with same
level of NP with
buyback of shares.
Book Value Equity Share Capital + It refers to the owners High BVPS
per Share Reserves& Surplus/ stake on a per share indicates high
Number of equity basis at any point of retention and
Shareholders time low pay out
policy
Dividend per Profit used for Equity It shows the amount Higher the
Share dividend/ Number of of dividend amount of
equity Shareholders distributed per equity dividend
share investment. distributed less
Also reveals the the amount
attitude of corporate ploughed back
management towards
dividend policy.
Cash per Cash balance/ Number Indicates Cash per Higher CEPS
share of equity Shareholders rupee earned by the higher the
owners. liquidity of the
firm.
Payout ratio Dividend per Share/ The percentage of Higher the
Earnings per share *100 earnings distributed amount
by way of dividends distributed lesser
the reinvestment
Earning yield EPS/CMP Suppose a 12%yield If the investors
implies that the firm is pay more for the
required to earn 12% stock the yield
on common stock will decline.
value.
Dividend DPS/CMP It shows the Return to an
yield immediate return v/s investor comes
CMP in two forms
dividend yield
and capital gains.
If yield is low
they are content
with the
expectation of
rapid growth in
dividend and
consequent
capital gains.
Price/Earning Current market price/ It measures the price Higher P/E
Earnings per share that investors are indicates that
prepared to pay for investor perceive
each rupee of earnings that the company
has good growth
opportunities,
less risk and
stable earnings.
Price/BVPS Current market price/ Indicates the price High ratio may
Book Value per Share which a shareholder is indicate that the
willing to pay to stock is
acquire a portfolio overvalued and
vice versa.
Price/Cash Price/PAT+Depreciation It indicates the Higher ratio
flow per number of times the shows that the
Share stock is selling on its company is cash
cash earnings. rich and risk
averse.
Cash flow PAT+Depreciation / It indicates the returns Higher the better
per Share/ Price the stock is earning in
Price cash
Price/Sales Price/Sales
EBIDTA/ EBIDTA/ Enterprise It indicates the It indicates the
Enterprise Value relationship between returns you
Value the EV, the market expect on
EV=Market cap. +Debt- value of the company resources
cash-investments and EBIDTA, the deployed .
operating profit of the
company.
Enterprise Enterprise It indicates the
Value/EBID Value/EBIDTA number of times
TA -do- the earnings you
are valuing the
company.
Enterprise Enterprise Value/Net It indicates the It indicates the
Value/Net Sales relationship between number of times
Sales the EV, the market the sales you are
value of the company valuing the
and Sales, of the company
company
Market Market caps. / Sales The market cap An incremental
caps. / Sales Market usually responds to change in market
caps=Outstanding the changes in sales. cap is more than
shares*CMP But one concern is the incremental
that if topline change in sales
increases and the for many
bottom line does not companies.
increase, as the
company is not able to
cut down the costs. As
a result the ratio will
be low.
PEG ratio (P/E)/Growth It expresses the If PEG is below
relationship between a 1 it is a good buy
stocks’ current P/E and sell the stock
multiple and the rate when P/E
of company’s exceeds their
expected growth. growth rate by
30% or more.
Thus lower the
PEG the more
value one gets
for his money.
Activity
Ratios
Inventory Average Stock/Cost of The company sells Higher the ratio
days goods sold *365 goods regularly and if better the
the frequency of sales utilization of
is more it is a assets.
symptom of efficiency
Debtor days Debtors/Net Credit This ratio shows the Lower the
Sales*365 debtor turnover and collection period
collection period faster the cash
respectively. realization and
better the
liquidity
Creditor days Creditor/ Net Credit It refers to the time Longer the credit
Purchases *365 taken to pay the payment period
creditors and its will improve the
ability to buy on liquidity of the
liberal Credit terms. business

Liquidity
ratio
Current Ratio CurrentAssets/CurrentLi Indicates the Capacity The Standard
abilities of the company to Current ratio is
respond to maturing 2:1 which shows
obligation that it will have
no problem of
settling its short-
term obligations.
Quick Ratio Current Assets- Indicates the Capacity The Standard
Inventories/ Current of the company to Quick ratio is 1:1
Liabilities respond to maturing which shows that
obligation by it will have no
excluding Inventories, problem of
which is a least liquid settling its short-
asset. term obligations.
Cash ratio Cash at bank +Short It indicates the ready The higher the
term securities/Current cash available to meet cash position
Liabilities maturing obligations ratio less the role
as Acid test ratio can of receivables in
be misleading because quick ratio.
of the adverse
influence of accounts
receivables
Inventory/Gr Inventory/Gross It indicates the extent A high ratio
oss working working Capital to which resources are indicates the
Capital committed in the least adverse mix of
liquid item current assets.
‘inventory’.
Inventory/Ne Inventory/Current It may be high either A high ratio in
t working Assets-Current because of inventory this regard
Capital Liabilities. accumulation or indicates poor
because of excess management of
dependence on current inventories.
liabilities or a
combination of both.

Net working Net working The extent of long- The higher this
Capital/Curre Capital/Current assets term funds used for ratio, the lesser
nt assets financing short-term is the firms’
uses of funds. reliance on
Current liability.
Hence higher the
liquidity.
Interval Quick Assets/Average It shows how long the It shows how
measure daily expenses on liquid assets of the long the liquid
operations. firm will suffice to assets of the firm
meet its operating will suffice to
expenses. meet its
operating
expenses.
Leverage
ratios
Debt/Equity Long term Indicates the extent of If the owners’
ratio debt/Shareholders fund leverage and the role contribution to
of borrowed funds the business is
vis-à-vis Owned funds more than the
outsider
contribution then
the company will
not find it
difficult to repay
the long-term
borrowing.
Networth/Tot Networth/Total assets It indicates the Higher the ratio
al assets contribution of stronger the
networth to total foundation of
assets capital structure
and greater the
protection to
sales.
Coverage
ratios
Interest PBIT/Interest Charge It indicates the Higher the ratio
Coverage availability of profits better the
ratio to pay interest performance
regularly to the long
term creditors of the
company.
Dividend NPAT/preference The preference
coverage dividend shareholders may be
ratio. interested in knowing -do-
whether they will get
preference dividend
regularly
Fixed EBIDLT/debt It measures debt-
charges interest+lease rentals+ servicing ability
coverage (loan repayment comprehensively. -do-
ratio instalment/1-t)+ Fixed charges which
(preference dividend/1- are not tax deductible
t) must be tax adjusted.
Turnover
ratios
Sales/Fixed Sales/Fixed Assets Indicates whether the Too high a ratio
Assets Fixed assets have indicates
been effectively excessive
utilized by comparing activity signaling
sales under investment
and low ratio
indicate want of
adequate activity
and over-
investment.
Sales/Total Sales/Total Assets It indicates the -do-
Assets utilization of the
resources entrusted to
enterprise.
Sales/Current Sales/Current Assets Indicates whether the High ratio
Assets Fixed assets have indicates
been effectively inadequacy of
utilized by comparing investment in
sales Current assets
could cause
liquidity
problems and is
a sure sign of
over trading.
Sales/Capital Sales/Capital Employed It indicates the High ratio
Employed performance with indicates the
respect to owned efficient use of
funds and owed funds. resources but an
unduly high ratio
because of strict
credit policy is
not desirable. A
low ratio
indicates
excessive
investment or
deficiency in
market
performance.

Inventory Sales/Inventory It indicates the Higher the


turnover ratio frequency with which inventory
the concerned item is turnover greater
replaced. the frequency
with which
replacement
takes place.

Sales/Net Sales/Net Working It indicates the sales Higher the ratio


Working Capital generated per rupee of better the fund
Capital long term funds used utilization.
to finance working
capital
Dupont
model
Return on (PAT/Sales)*(Sales/Ass Profitability*efficienc
Pp By splitting the
Networth ets)* y* basic rrrrrratio into
(Assets/Networth) leverage its comp--------onents
it reveals a
detadetailed
infoinformation on
comcompanys’
oopoperations.
ra
Return on (Sales/Average total Efficiency* -do-
Assets assets)*(PAT/Sales) Profitability

In Depth Analysis Of Ratios

Liquidity Ratio-It indicates the firms’ ability to pay bills promptly. The short-term
creditors hold bonds against the firm and are interested in current payment of
interest and eventual repayment of Principal.

Current Ratio- It shows the ability of an enterprise to meet its current obligations.
A firm that has a large amount of cash and accounts receivables is more liquid than
a firm with a high amount of inventories in its current assets, though both the firms
have the same current ratio.

The standard Current ratio is 2:1 was evolved keeping in view the potential
depreciation of current assets in the event of realization on liquidation. Thus, fifty
percent depreciation would still leave a rupee of cash to meet a rupee of obligation.
This ratio can also be misleading if a company borrow a large sum from the bank
and invest it in the short-term securities to inflate the ratio. It might be preferable
to net off the short-term debt when calculating the ratio.

A firm may have a good current ratio as large as 2,but the current assets may be
composed of dead or slow moving inventories and bad debts, which the firm is
unable to write off for fear of showing less profit. While financial strength of the
business is really weakening, a high current ratio is giving a false perception of
liquidity.

For every Rs 100 lacs gross sales made by a company as much as Rs. 60 lacs gets
blocked in current assets, releasing only Rs. 40 lacs to the system to pay for current
obligation this may result in delay in payment to the creditors. A very low ratio
implies that a company has barely enough to meet its needs.

Quick Ratio-Here the inventories that are least liquid of the current assets are
excluded from the ratio. Inventories have to go through a two-step process of first
being sold and converted into receivables and secondly collected. Sometimes it so
happens that the customer is not buying and the firms’ warehouse is stuffed full of
unwanted goods. It may also not be reliable if accounts receivables particularly
potential bad/doubtful debts dominate the quick ratio.

Profitability Ratios-These measures the efficiency of the firms activities and its
ability to generate profits.

Net Profit margin-It shows the earnings left for shareholders both equity and
preference as a % of Net Sales. When making comparisons between firms it makes
more sense to recognize that firms that pay more interest pay less tax. We should
calculate profits that the company would pay if it were all equity financed. We also
need to look at the relative share of other income because this item is where most
companies show extraordinary profits to boost their bottomline.

Return on Equity/Networth- It indicates the returns that shareholders have


earned on their funds utilized in the business. It examines earnings in relation to
Capital. The structure of capital has direct impact on. ROE, which will be
explained further. The company should earn a return on equity that is greater than
the cost of equity to cover its costs.
If there is a case of overcapitalization which results from excess capital raised in
excess of the capacity to earn adequate return or over valuation of fixed assets. It
causes a fall in the shareholders equity. This will have a chain reaction on
decreased EPS, DPS, CMP and adverse corporate image. There is a positive
correlation between RONW and returns on the stock as when we compare similar
companies with same business model in a sector

ROE reacts to the changes in debt and equity and the rate of interest it pays on
debt. That makes it difficult to say whether ROE rises or falls for operating or
financial reasons. With ROE as its goal, management may be tempted to accept
substandard project that happened to be financed with debt and pass by very good
ones if they must be financed with equity.

Using Dupont model we can dig deeper into the various components to provide
information on company’s operations
Profitability-It represents whether the company is able to sell its goods and
services competitively in the market. Higher profitability contributes towards
better returns.
Efficiency-It represents how hard the company has put its asset to work. The
companys’ asset must translate into sales. For example the capital-intensive
companies like Reliance Petroleum that has set up world-class refinery at the cost
of Rs.14000 crs. The shareholders are not interested in setting up a plant, what he
is interested in is the revenues that can be generated by the asset built at such a
cost. Even if the revenues are good but the company has to pay interest worth
Rs.960 crs and depreciation of Rs.687 crs. on the assets the returns are going to be
low.
Leverage-The mode of financing the operations and assets also hold the key to
returns. The higher component of debt in the capital structure normally results in
higher returns.

For return on networth to be higher, business has to score on these three


parameters.

Return on Capital employed- It reflects the overall earning capacity of the


business. Return on Capital employed does not discriminate between different
types of capital. If ROCE is same as WACC than it has paid for its capital i.e. no
gain no loss scenario. Finally what is left for the business is returns less cost of
capital which all the business should strive to achieve.
ROCE takes operating profit after depreciation, as depreciation is a non-cash
expenses that the company sets aside to replace its asset in the future. Thus
depreciation is a real cost of production and must be deducted from the operating
profit.

We must also add back interest as ROCE calculates the returns to all providers of
capital. Capital consists of equity and debt. On debt you have to pay interest and
PAT only belongs to equity shareholders. ROCE is the return to all the providers of
capital so if we do not add back interest we will be distorting the real picture. As
interest is a tax-deductible expense we have to take interest adjusted for tax.

Say your tax rate is 50%. You have two scenarios, in both cases; say your profits
are Rs200. In one, you have to pay an interest of Rs100 and in the other zero.

Post tax profits of the two businesses will be

A B Difference
EBIT Rs200 Rs200 -
Interest (Rs100) - (Rs100)
PBT Rs100 Rs200 (Rs100)
Tax (@50%) (Rs50) (Rs100) (Rs50)
PAT Rs50 Rs100 (Rs50)

In other words the business that pays an interest of Rs100 has a post-tax profit
lower by only Rs50 because of a lower tax, therefore this is called a tax shield. The
effective cost of interest is only Rs50 and not Rs100. So when we have to add
back interest we also have to add back interest adjusted for tax.

Secondly ROCE is indifferent to the mode of financing. These are described in


three different scenarios of diverse debt/equity patterns. In case 1 the company has
funded 70% of its business from debt while at the other extreme, case 3, 70% of
the capital is equity. All other activities are the same but the company with high
leverage has maximized returns to company X shareholders in the form of higher
RONW

Company X Ltd. 1 2 3
Equity 30 50 70
Debt 70 50 30
Sales 100 100 100
Operating profit 35 35 35
Depreciation 10 10 10
Interest 11 8 5
PBT 14 17 20
Tax 5 6 7
PAT 9 11 13
RoNW 29.9% 22.1% 18.8%
RoCE 25.0% 25.0% 25.0%

Although debt enhances the returns it also increase the riskiness to the company as
it entails the fixed obligation to pay the interest. If the income is consistently low
or negative not only is the tax shield eliminated, the cash flow burden of interest
payment on high debt may make the firm insolvent.

Suppose if the two companies have the same RONW, then the company having
lesser debt is better all other things being unchanged as it has lower fixed liabilities
and less risk.

Return on Assets-Total assets is what the company has during the course of its
business. We consider the average of total assets for two years as the balance sheet
gives a snapshot of the financials as on a particular date. What we want is the
assets that have been in use for the entire year .An enterprise who retain older
mostly depreciated assets reports much higher than those who invest in new assets
or revalue assets from time to time.

Turnover Ratios-

Asset turnover ratio-A high ratio could indicate that the firm is working close to a
capacity or stretching a business beyond a particular point which may be rather
counter productive. It may prove difficult to generate further business without an
increase in invested capital. Higher ratio may not necessarily mean more profit.
More selling could be possible because of increase in marketing expenses, liberal
credit with risk of potential bad and doubtful debt .All this may result in additional
borrowings.

Low ratio may indicate over investment or over stocking unsupported by adequate
sales, obsolete inventory/equipment causing huge losses followed by dull business
and bad buying. If the assets are financed out of debt the creditors position will be
in danger as sales are decreasing.

Fixed Asset turnover ratio-It shows the extent to which the infrastructural assets
are productively used. When fixed assets of the firm are old and substantially
depreciated the ratio tends to be high.

If the ratio is low, the technical capacity of the assets might have fallen due to age
or there may be production bottleneck or there are unresolved labour problems
or it may be a failure of marketing function of the enterprise. Externally the firm
may be losing in competition due to both technological and product obsolescence
or general recession in the economy.

Note- Goodwill is a special kind of an intangible asset which represents super


earning capacity of an enterprise. But existence of GW beyond a reasonable period
represents to the fact that enterprise might already have lost the GW because its
earning capacity is no longer such that it could write off the GW faster. Goodwill
is excluded while calculating ratios relating to total assets.

Sales/Net working capital-It indicates that the increase in sales volume may lead
to increase in receivables and cash. The organization has to invest more in
maintaining adequate inventory. These increase in current asset is somewhat
offset by increased current liability in the form of purchase requirement.
This will result in greater accounts payable balance as well as higher accrued
wages due to increase in labour activity and possibly short term loans to
support the higher volumes.

Sales/Inventory-High turnover indicates relatively less commitment to funds and


therefore low risk of unsalable stock, low margin facilitating high volume and
efficient utilization of capital High turnover need not mean profit if sales are being
made at loss, additional sales are generated through disproportionate amount of
marketing expenses, inventory is replaced by customers who are bad/doubtful.

Low Inventory turnover means the money blocked in current assets. If this is in
addition to pressure from creditors due to high leverage and bad business times, the
company will be in trouble.

Leverage/ Coverage ratios


Debt/Networth- The components of Debt/Equity may vary across different sectors
depending upon the type of business and pattern of cash flows. If the debt content
is more it will increase the risk for its long-term finance providers. High D/E
indicates high risk as profits can fluctuate but your commitment to pay interest to
lender is fixed. As a result most of the firms income will go for servicing the debt
and net income will reduce thereby affecting long-term earnings of the company.
Low ratio indicates that the company has unutilized debt capacity but its low
operating income does not allow it to make full utilization of this capacity. It may
also be that the company does not have many assets to raise further long-term
loans.

Interest Coverage ratio—It tells us how many times the firm can meet the interest
payment associated with debt. Higher the ratio greater the comfort to lender.
We can add back the depreciation to arrive at modified Interest coverage
ratio. A high ratio may imply a risk averse management who inspite of
making a good profit prefers to keep the Debt/Equity ratio at a low level.

It also implies that a company is using more free market credit than interest
bearing loans. In that case the long-term debt equity ratio may be low but the
total debt equity ratio will be high. On the contrary a very low interest
coverage ratio may indicate a risk prone management with a highly geared
capital structure or the loan funds are not being paid.

Activity ratios—It measures how efficiently the assets are employed by the firm.

Cost of goods sold/Average Inventory-Low ratio may indicate that the market for
the companys’ product is shrinking. Its manufacturing system is not able to prune
down its production may be to avoid layoffs. If situation is allowed to continue the
company may soon find itself submerged under piles of unsold stock that will
choke the supply of the company so essential for its survival.

It may fall if a company launches a big promotional campaign and all stores are
filled up in anticipation of increased sales. If the product is successful the turnover
ratio will increase thereby covering all the costs otherwise there will be piles of
unsold stock lying at the stores. High ratio may also indicate low level of
inventory, frequent stock outs, and too many small orders for inventory.

Debtor turnover ratio—The speed with which accounts receivable is converted


into cash. Higher the receivables ratio greater the liquidity of the firm. We always
take average debtors because sales are seasonal or may have grown considerably
towards the end of the year. Otherwise it will show high debtors in relation to the
sales.

If the ratio is high the company may face a fund crisis as major sales are blocked in
debtors. Due to competition and decrease in market share the company is following
a liberal credit policy. The company may be losing out on competition for several
reasons like recession in the market, technology obsolete. In addition to these if
major customers are PSU units that company will have huge debtors. As a result
the collection policy has slowed down, profits will be less than expected because
of bad debts and need to finance a large investment in receivables.

Too low a ratio indicates a strict credit policy as a result sales will be less and
thereby profits.

Valuations ratio

Price/Earning multiple—P/E is a proxy of number of characteristic of the firm


like payout ratio, risk and growth, rate of earnings and financial stability. It reflects
more of market moods and sentiments. Higher the risk to the firm, lower the P/E.
High P/E may indicate that investors think that the firms have good growth
opportunities or that its earnings are safe .It can also mean temporary depressed
earnings, if a company has just break even reporting zero earnings its P/E ratio is
infinite.

Earnings that firms report are book or accounting figure thus the trouble centres
on ‘E’. Almost any firms reported earnings could be changed substantially by
adopting different accounting procedure, change in depreciation policy, inventory
policy , buy back of stock, cutting back on provision for bad debts, increase in
other income may be due to flat sales. Higher the P/E greater the financial strength
of the company as perceived by the investor. It also indicates that the investor is
willing to pay more for the shares because they expect the future earnings of the
company to be substantial. They are willing to wait for a longer period to recover
their investment.

For e.g. if you have purchased 100 shares of company X at Rs.35 i.e. Rs.3500 &
EPS is 3.50,P/E is 10.You will earn Rs.350 in the first year and will be willing to
wait for 10 years for return on your initial investment. This is because you perceive
the financial strength of the company to be stable coupled with various factors
explained above. To guage the integrity and reasonableness of P/E ratio compare it
to those of similar companies in the sector and industry average.

Book value per share—It refers to the owner stake in the enterprise at any point
of time. High BVPS also indicate high retention and low payout policy and greater
for reinvestment to take advantage of reinvestment opportunities. If earnings are
not in tandem to the amount of resources deployed it will depress EPS and there
will be inclination towards over capitalization. B/V is considered to be accounting
value of each share.

Book Value should exclude revaluation reserve as the companies can revalue their
assets and this will result in inflated book value. Also as shareholders do not have
any claim on revaluation reserve as it is not distributed to them in any case
including issue of bonus shares. B/V should not be taken at its face value. Investors
should check the quality of the assets while using B/V Suppose two companies
have the same B/V but the company with the higher component of cash and
marketable securities is better off than the company with higher component of
fixed assets, high levels of debtors or inventory. Hence the concept of asset has to
be considered carefully while using the component of B/V.

Price/Book value per share—P/BV reflects the contribution of a firm to the


netwealth of the society. If a ratio is more than one than the company has
contributed to the creation of netwealth of the society. If it is equal to 1than the
company has neither created nor detracted from the netwealth of the society.

If market price is low than BVPS, it is possible that the stock is underpriced.
Similarly high P/BV only indicates a possibility of overvaluation. For the
companies that are fancied by the market price tends to be more while for not so
darling companies B/V is generally higher than CMP.

Market price reflects not just the accumulated networth but also the future earnings
of the company like management vision, company’s distribution and brand
strength. If the ratio is high that does not mean that the stock is expensive. BV of
an asset reflects its original cost. P/BV may significantly deviate from the MV if
the earning power has either increased or decreased.

Firms with negative earnings that cannot be evaluated using P/E can be evaluated
using P/BV ratio. But if a company has a sustained string of negative earnings
P/BV can become negative. This ratio is not relevant to service firms, as they do
not have significant fixed assets.

The ratio also varies due to market conditions. During Bull market CMP is more
than the market price. While in bear market CMP is less than the market price.

P/E/Growth- It is important that we look at the forward earnings growth rate and
not the past earnings growth rate .The reason behind using this ratio is that it might
be good to hold an expensive stock if the market is not fully valuing the potential
growth of its earnings. This ratio helps the investor at what price a given stock is
good to buy and at what price a good sell thus giving them a guide to best prices to
buy and sell stock in which one is interested.

For e.g. if a stock has a P/E of 50 and company is expected to grow 10% in coming
years its PEG is 5.This indicates that a stock is selling 5 times its estimate of
worth. However if the expected rate of growth is 40% then PEG is one, indicating
that the company is priced well according to earnings and growth.

Enterprise Value/EBIDTA- Enterprise Value tells us the value of the firm as the
market sees it. It does not say if that is a fair value of the company nor does it
concern itself with the balance sheet value of the company. It says that if you were
to buy over the company what would you need to pay today. You need to buy all
its equity at its market price. You also need to take the responsibility of its debt.
And finally you inherit some cash and investment and your cash outflow stands
reduced by that amount.

This ratio is useful when trying to estimate the value of the company in a possible
take over situation. For example if you want a return of 20% of return on the funds
u have deployed to buy this company then maximum price you would be willing to
pay is 5 times EBIDTA. This ratio tells us whether the stock is overpriced or under
priced and whether it is worth buy a company Suppose if the market cap is 500 and
EBIDTA is 50 then the returns u are getting is just 10%, then it is not worth buy a
company.