Financial Ratios

Financial Ratio or accounting ratios represents a relative measure where both the numerator and denominator are financial numbers. Financial ratios allow for comparisons between companies, industries, different time periods for one company or a single company and its industry average.

There are three classes of financial ratios:

1 Balance sheet ratio - where both the variables are taken from the balance sheet

2 Profit and loss ratio - where both the variables are taken from P & L account

3 Mixed ratio -where one variable is taken from balance sheet and other from P & L statement

Four Windows Analysis

Among the dozens of financial ratios available, the financial ratios can be organized into four main categories:

1. Liquidity Ratios

2. Efficiency Ratios

3. Profitability Ratios

4. Leverage Ratios

Liquidity Ratios
Current Ratio	Current Assets / Current Liabilities	Ascertains whether a company's short-term assets are readily available to pay off its short-term liabilities Higher ratio means a more liquid current position
Quick Ratio	(Current Assets - Inventory) / Current Liabilities	Refines the current ratio measuring the amount of the most liquid current assets there are to cover current liabilities The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which may be more difficult to turn into cash
Financial Slack	Cash & Bank balances / Total Assets * 100
Efficiency Ratios
Overall Efficiency  (or total assets turnover)	Sales / Capital Employed
Fixed Assets Turnover (or efficiency)	Sales / (Net Block + Capital WIP)
Working Capital Turnover (or efficiency)	Sales / Working Capital	Negative working capital turnover means that collections of firm are better and payments of the firms are slower. In other words, it means higher debtor's turnover and lower creditor's turnover. Only firms that have excellent negotiations power can do this.
Inventory Turnover	Cost of Goods Sold / Average Inventory
Debtors Turnover	Credit Sales / (Average Debtors + Average Bills Receivable)
Creditors Turnover	Credit Purchase / (Average Creditors + Average Bills Payable)
Working Capital Cycle
Average Inventory Holding Period	(Average Inventory / Cost of Goods Sold) * No. of Days / Months in a Year	Net working capital cycle = gross working capital cycle - creditors cycle Lower net working capital cycle represent better management of working capital
Debtors Collection Period	(Average Debtors + Average Bills Receivables) / Credit Sales * No. of Days / Months in a Year
Suppliers Credit Period	(Average Creditors + Average Bills Payable) / Credit Purchases * No. of Days / Months in a Year
Profitability Ratios
Sales Based
Gross Profit Margin	(Sales - Cost of Goods Sold) / Sales * 100
Operating Profit Margin	(Operating Profit / Sales) * 100
Net Profit Margin	(Profit After Tax / Sales) * 100
Asset Based
Return on Total Assets (ROTA)	(Profit Before Interest and After Tax / Total Assets) * 100
Return on Capital Employed (ROCE) or Return of Investments (ROI)	(Operating Profit / Capital Employed) * 100
Indicators for Shareholders
Return on Net Worth (RONW)	(PAT / Net Worth) * 100
Dividend Per Share (DPS)	Proposed Dividend / Number of Shares
Basic Earnings Per Share (EPS)	(PAT – Dividend on Preference Shares) / Weighted Average Number of Equity Shares
Pay-out Ratio	(Proposed Dividend/PAT) * 100
Leverage Ratios
Debt Equity Ratio (D/E)	Long-term Debt / Equity
Debt Service Coverage Ratio (DSCR)	Cash Flow from Operating Activities After Tax / (Interest + Installments Paid during the year on long-term loans)
Debt Ratio	Long-term Debt / (Long-term Debt + Equity) * 100
Interest Coverage Ratio	(PAT + Interest) / Interest	The lower the ratio, the more the company is burdened by debt expense
Market-Based Ratios
Price Earning Multiple	Market Price/Earnings per share	High PE (on high denominator) is good from existing investor perspective Low PE (on high denominator) is good from new investor point of view
Price-to-Book Multiple	Market price/Book value per share
Dividend Yield (on market value basis)	(Proposed Equity Dividend / Market Capitalization) * 100
Total Return to Shareholders (TRS)	[Dividend Per Share + (Closing Market Price – Opening Market Price)] / Opening Market Price

Capital Employed = Total Assets - Current Liabilities = Owner's Equity + Non-current Liabilities
 
Gross Working Capital = Total Current Assets
 
Net Working Capital = Current Asset - Current Liabilities

Net Worth = Total Assets - Total Liabilities
 
Gross block = Total Assets without Depreciation

DuPont Analysis

DuPont analysis tells us that the financial ratios are not independent and it tells the interdependence of the same. DuPont analysis tells that the return on equity (ROE) is affected by three things:

1 Operating efficiency, which is measured by profit margin

2 Asset use efficiency, which is measured by total asset turnover

3 Financial leverage, which is measured by the equity multiplier

The DuPont analysis approach helps in identifying and pinpointing the reasons behind high or low profitability of the firm.

DuPont analysis of ROE
ROE = PAT / Equity
ROE = PAT / Sales * Sales / Total Assets * Total Assets / Equity
ROE = Profit Margin * Total Asset turnover * Financial Leverage Ratio