Ratios are the symptoms or indication or sign of health of an organization like blood pressure, pulse or temperature of an individual. Ratios are the indicators for further
Now we will understand about various types of ratios.
Now these are various types of ratios. Now before starting discussing about above types, it is important to understand that only Ratio Analysis is not enough, you have to interpret this analysis. Analysis means methodical classification of data and presentation in a simplified form for easy understanding. Interpretation means assigning reasons for the behavior in respect of the data, presented in the simplified form.
Liquidity Ratios
It measures the ability of the firm to meet its short-term obligations, i.e. capacity of the firm to pay its current liabilities as and when they fall due. Thus these ratios reflect the short-term financial solvency of a firm.
A firm should ensure that it does not suffer from lack of liquidity. The failure to meet obligations on due time may result in bad credit image, loss of creditors confidence, and even in legal proceedings against the firm on the other hand very high degree of liquidity is also not desirable since it would imply that funds are idle and earn nothing. So therefore it is necessary to strike a proper balance between liquidity and lack of liquidity.
The various ratios that explains about the liquidity of the firm are
- Current Ratio
- Acid Test Ratio / quick ratio
- Absolute liquid ration / cash ratio
Current ratio
Current ratio is defined as the relationship between current assets and current liabilities. It is also known as working capital ratio. This is calculated by dividing total current assets by total current liabilities.
Current assets (Debtors- [Debtors are people who "owe" you], stock, cash) are those that can be realized within a short period of time, generally one year. Similarly, current liabilities (creditors, bank overdraft, short term loan) are those that are to be paid, within a period of one year.
Interpretation
Current ratio represents a margin of safety for creditors. Realization of assets may decline. However, all the liabilities have to be paid, in full. As a conventional rule, a current ratio of 2:1 is considered satisfactory. The rule is based on the logic that in the worst situation, even if the value of current assets becomes half, the firm will be able to meet its obligations, fully.
A current ratio of 1.33: 1 is considered as the minimum acceptable level by banks for providing working capital finance. Looking at the mere ratio in figures, no conclusion is to be arrived at. Current ratio is a test of quantity, not test of quality. It is essential to verify the composition and quality of assets before, finally, taking a decision about the adequacy of the ratio.
This means high current ratio is favorable? Correct?
Generally is it favorable. But a high current ratio, due to the following causes, may not be favorable:
1. Slow-moving or dead stock/s, piled up due to poor sales.
2. Figure of debtors may be high as debtors are not capable of paying or debt collection system of the firm is not satisfactory
3. Cash or bank balances may be high, due to idle funds.
On the other hand, a low current ratio may be due to the following reasons:
1. Insufficiency of funds to pay creditors.
2. Firm may be trading beyond resources and the resources are inadequate to the high volume of trade.
Quick Ratio
It has been an important indicator of the firm’s liquidity position and is used as a complementary ratio to the current ratio Liquid assets are those that can be converted into cash, quickly, without loss of value. Cash and balance in current account with bank are the most liquid assets. Other assets that are considered, relatively, liquid are debtors, bills receivable and marketable securities (temporary, quoted investments purchased, instead of holding idle cash). Inventories and prepaid expenses [Prepaid expense is expense paid in advance but which has not yet been incurred ] are excluded from this category.
Interpretation
Liquid ratio of 1:1 is, normally, considered satisfactory. However, firms with the ratio of more than 1:1 need not be liquid and those having less than the standard need not, necessarily, be illiquid. It depends more on the composition of liquid assets.
Debtors, normally, constitute a major part in liquid assets. If the debtors are slow paying, doubtful and long outstanding, they may not be totally liquid. So, firms even with high liquid ratio, containing such type of debtors, may experience the problem in meeting current obligations, as and when they fall due.
On the other hand, inventories may not be, totally, non-liquid. To a certain extent, they may be available to meet current obligations. So, all firms not having the liquid ratio of 1:1 may not experience difficulty in meeting the current obligations, depending on the efficient realization of inventories.
Cash Ratio or Absolute Liquid Ratio
It shows the relationship between absolute liquid or super quick current assets and liabilities. Absolute liquid assets include cash, bank balances, and marketable securities.
Leverage or solvency Ratio
The solvency or leverage ratios throws light on the long term solvency of a firm reflecting its ability to assure the long term creditors with regard to periodic payment of interest during the period and loan repayment of principal on maturity or in predetermined installments at due dates.
Leverage ratios indicate the mix of debt and owners’ equity in financing the assets of the firm. These ratios measure the extent of debt financing in a firm.
To whom these ratios are important?:
Short-term creditors like suppliers of raw materials and banks that provide working capital are concerned with short-term solvency of the firm.
On the other hand, long term-creditors like debenture holders, financial institutions that provide long term capital are concerned with long-term solvency
Debt Equity ratio
Debt-Equity Ratio is also known as External-Internal Equity Ratio. This ratio is calculated to measure the relative claims of outsiders and owners against the firm’s assets. The ratio shows the relationship between the external equities (outsiders’ funds) and internal equities (shareholders’ funds).
* Net Worth = Equity Share Capital + Preference Share Capital + Reserves and Surplus
Interpretation
Debt-Equity Ratio indicates the extent to which debt financing has been used in business. This ratio shows the level of dependence on the outsiders.
As a general rule, there should be a mix of debt and equity. The owners want to conduct business, with maximum outsiders’ funds to take less risk for their investment. At the same time, they want to maximise their earnings, at the cost and risk of outsiders’ funds. The outsiders (lenders and creditors) want the owners’ share, on a higher side in the business and assume lower risk, with more safety to their funds.
Total debt to net worth of 1:1 is considered satisfactory, as a thumb rule. In some businesses, a high ratio 2:1 or even more may be considered satisfactory, say, for example in the case of contractor’s business. It all depends upon the financial policy of the firm, risk bearing profile and nature of business.
What is impact of high ratio?
A high debt-equity ratio may be unfavorable as the firm may not be able to raise further borrowing, without paying higher interest, and accepting stringent conditions. This situation creates undue pressures and unfavorable conditions to the firm from the creditors.
Debt Service (Interest Coverage) Ratio
Debt ratio is static and fails to indicate the ability of the firm to meet interest obligations. The interest coverage ratio is used to test the firm’s debt-servicing capacity. This shows the number of times the earnings of the firms are able to cover the fixed interest liability of the firm.
As taxes are computed on earnings after deducting interest, earnings before taxes are taken. Depreciation is a non-cash item. Therefore, funds equal to depreciation are also available for payment of interest charges. So, the interest coverage ratio is computed by dividing the earnings before depreciation, interest and taxes (EBDIT) by interest charges.
Interpretation
This ratio indicates the extent to which earnings can fall, without causing any embarrassment to the firm, regarding the payment of interest charges. The higher the IC ratio, better it is both for the firm and lenders. For the firm, the probability of default in payment of interest is reduced and for the lenders, the firm is considered to be less risky. However, too high a ratio indicates the firm is very conservative in not using the debt to its best advantage of the shareholders. On the other hand, a lower coverage ratio indicates the excessive use of debt.
Debt Service Coverage Ratio (DSCR)
Now in Debt Service (Interest Coverage) Ratio, repayment of installment liability is not included.
Debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests inability of firm’s profits to serve its debts whereas a DSCR greater than 1 means not only serving the debt obligations but also the ability to pay the dividends. This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR is very important from the view point of the financing authority as it indicates repaying capability of the entity taking loan.
Activity Ratio
Firm invests funds of outsiders (lenders and creditors) and shareholders in various assets in business to make sales and profits. The better the management of assets, more would be sales and higher would be the profit.
Activity ratios reflect the management of assets and their effective utilization. If assets are converted into sales, with speed, profits would be more. Activity ratios bring out the relationship between the assets and sales.
These ratios are called Turnover Ratios. For example, funds invested in inventories are converted or turned over into sales. Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes the assets, in particular, debtors and stock.
Inventory Turnover Ratio
Inventory turnover ratio is also known as stock turnover ratio. This is generally calculated by dividing sales by calculated by inventory. However, it may also be calculated as dividing cost of goods sold by average inventory.
Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
= Net Sales – Gross Profit
Interpretation
Inventory turnover ratio shows the velocity of stocks. A higher ratio is an indication that the firm is moving the stocks better so profitability, in such a situation, would be more. However, a very high ratio may show that the firm has been maintaining only fast moving stocks. The firm may not be maintaining the total range of inventory and so may be missing business opportunities, which may otherwise be available.
It is better to compare the turnover ratio, with the industry or its immediate competitor.
Days of Inventory Holdings: If we want to know the holding of inventory in the form of number of days, the following formula helps us.
Ideal Standard: There is no standard ratio. The ratio depends upon the nature of business. The ratio has to be compared with the ratio of the industry, other firms or past ratio of the same firm.
Every firm has to maintain certain level of inventory, be it raw materials or finished goods, to carry on the business, smoothly, without interruption of production and loss of business opportunities. Inventory Turnover Ratio is a test of inventory management.
This level of inventory should be neither too high nor too low. If the ratio is too high, it is an indication of the following:
(i) Blocking unnecessary funds that can be utilized somewhere else, more profitably.
(ii) Unnecessary payment for extra godown space for piled stocks.
(iii) Chances of obsolescence and pilferage are more.
(iv) Likely deterioration in quality and
(v) Above all, slow movement of stocks means slow recovery of cash, tied in stocks.
On the other hand, if the ratio is too low:
(i) Stoppage of production, in the absence of continuous availability of raw materials and
(ii) Loss of business opportunities as range of finished goods is not available, at all times.
To avoid the situation, the firm should know the position, periodically, whether it is carrying excessive or inadequate stocks for necessary corrective action, in time.
Debtors’ (Receivables) Turnover Ratio
Firms sell goods on cash and credit. As and when goods are sold on credit, debtors (receivables) appear in accounts. Debtors are expected to be converted into cash, over a short period, and they are included in current assets. To judge the quality or liquidity of debtors, financial analysts apply following ratios, which are:
(a) Debtors turnover ratio
(b) Collection period
Debtors’ Turnover Ratio: Debtors turnover is found out by dividing credit sales by average debtors.
What is average Trade Debtors? Does it include Bill receivables also ?
The trade debtors for the purpose of this ratio include the amount of Trade Debtors & Bills Receivables. The average receivables are found by adding the opening receivables and closing balance of receivables and dividing the total by two. But when the information about opening and closing balances of trade debtors and credit sales is not available, then the debtors turnover ratio can be calculated by dividing the total sales by the balance of debtors (inclusive of bills receivables) given.
Now For E.g. ABC Ltd has net credit sales of Rs. 10,00,000 and Average Debtors balance of Rs. 1,00,000, giving the company debtors Turnover ratio of 10. Company management can compare this figure to prior years or even break it down to monthly/quarterly to determine trends in its debt collection.
Debtors’ turnover ratio indicates the number of times debtors are turned over, each year. The higher the debtors’ turnover, more efficient is the management of credit.
Collection Period: The collection period is calculated by
*360 days are taken in place of 365 for convenience in calculation only.
Signals of Collection Period
Debtors’ Turnover Ratio indicates the speed of their collection. The shorter the period of collection, the better is the quality of debtors. A short collection period indicates the efficiency of credit management. The average collection period should be compared with the credit terms and policy of the firm to judge the quality of collection efficiency.
Suppose, the firm’s credit policy is to extend 45 days credit and on calculation, the actual collection period is 60 days. This shows the laxity in collection. An excessively long collection period implies an inefficient credit and collection policy. On the other hand, too low a collection period is also not a favorable signal. The firm may be extending credit only to those customers, whose creditworthiness is beyond doubt so that there would be total certainty of payment, with no bad debts. The firm may succeed with no bad debts. But, in the process of rigid credit standards to have no bad debts, the firm may be missing the existing sales opportunities and, equally, possible improved profitability. If credit period is relaxed more, the firm may gain more sales and improved profitability, even after providing for the losses towards bad debts. The best way is to compare the collection period of the firm with the industry’s average collection period and decide whether the firm has to make any change in credit policy.
Total Assets Turnover Ratio
Assets are used to generate sales. If the firm manages the assets more efficiently, sales would be more and equally profits would be up. This ratio is calculated by dividing sales by total assets.
Importance: A firm’s ability to make sales indicates its operating performance.
Caution: This ratio should be interpreted, carefully. Between two firms, a firm having old assets, with lower depreciated book value of fixed assets, may generate more sales compared with a firm, with new fixed assets purchased, recently. The firm, with old assets, may generate a misleading impression of higher turnover, without any actual improvement in sales.
Working Capital Turnover Ratio
The WCT Ratio indicates the velocity of utilization of working capital of the firm, during the year. The working capital refers to net working capital, which is equal to total current assets less current liabilities. The ratio is calculated as follows:
Working capital is represented by the difference between current assets and current liabilities.
Importance: This ratio measures the efficiency of working capital management. A higher ratio indicates efficient utilization of working capital and a low ratio shows otherwise. A high working capital ratio indicates a lower investment in working capital has generated more volume of sales. Higher ratio improves the profitability of the firm. But, a very high ratio is also not desirable for any firm. This may also imply overtrading, as there may be inadequacy of working capital to support the increasing volume of sales. This may be a risky proposition to the firm. The ratio is to be compared with the trend of the other firms in the industry for different periods to understand the right working capital ratio, without resulting overtrading.
Creditors / Payable Turnover Ratio
In the course business operations of the firm, a firm has to make credit purchases and incur short-term liabilities. Before supply of goods, suppliers can check up the ratio to understand the normal period of payment, firm has been making, for the goods supplied. The ratio is calculated, similar to debtors’ turnover ratio. In the place of debtors, creditors are to be substituted and credit purchases in place of credit sales. The ratio can be calculated
Similarly, to understand the number of days the creditors are outstanding, the ratio is
Interpretation of Payment Period Creditors’ Turnover Ratio indicates the number of days the creditors are outstanding for payment. If the number of days is lower than the assured period of payment, it indicates liquidity of the firm. This would be good news to the suppliers as they can expect the payment, within the assured period.
Profitability Ratio
The last group of financial ratios, more often used, is Profitability Ratios. Profit is the difference between revenue and expenses over a period, usually, one year.
Profitability ratios are to measure the operating efficiency of the company. Besides management, lenders and owners of the company are interested in the analysis of the profitability of the firm. If profits are adequate, there would be no difficulty for lenders, normally, to get payment of interest and repayment of principal. Owners want to get required rate of return on investment.
Generally, two major types of profitability ratios are calculated:
- Profitability ratios based on sales
- Profitability ratios based on investment
I] Profitability ratios based on sales
Gross Profit Ratio
The first ratio in relation to sales is gross profit ratio or gross margin ratio. The ratio can be calculated by
Importance: The ratio reflects the efficiency with which a firm produces/sells its different products.
Gross Profit Ratio indicates the spread between the cost of goods sold and revenue. Analysis gives the clues to the management how to improve the depressed profit margins. The ratio indicates the extent to which the selling price can decline, without resulting in losses on operations of a firm.
High gross profit ratio is a sign of good management. Reasons could be:
- High sales price, cost of goods remaining constant
- Lower cost of goods sold, sales price remaining constant
- A combination of factors in sales price and costs of different products, widening the margin
- An increase in proportion of volume of sales of those products that carry a higher margin and
- Overvaluation of closing stock due to misleading factors.
Reasons for fall in gross profit ratio: Reasons may be:
- Purchase of raw materials, at unfavorable rates
- Over investment and/ or inefficient utilization of plant and machinery, resulting in higher cost of production
- Excessive competition, compelling to sell at reduced prices
Net Profit Ratio
Net profit is obtained, after deducting operating expenses, interest and taxes from gross profit. The net profit ratio is calculated by
Net profit includes non-operating income so the later may be deducted to arrive at profitability arising from operations.
Interpretation
Net Profit ratio indicates the overall efficiency of the management in manufacturing, administering and selling the products. Net profit has a direct relationship with the return on investment. If net profit is high, with no change in investment, return on investment would be high. If there is fall in profits, return on investment would also go down. For a meaningful understanding, both the ratios — gross profit ratio and net profit ratio — have to be interpreted together. If gross margin increases but net margin declines, this indicates operating expenses have gone up. Further analysis has to be made which operating expense has contributed to the declining position for control. Reverse situation is also possible with gross margin declining, and net margin going up. This could be due to increase of cost of production, without any change in selling price, and operating expenses reducing more to compensate the change.
Operating Expenses Ratios
To identify the cause of fall or rise in net profit, each operating expense ratio is to be calculated. While some of the expenses may be increasing and other may be declining. To know the behavior of specific items of expenses, the ratio of each individual operating expense to net sales should be calculated. The various variants of expenses are:
II] Profitability Ratios Based on Investment
Equity shareholders are the owners of the company. Profits belong to the owners of the firm who have invested their funds, in anticipation of return. If preference shares exist, then profits, after tax and dividend due to preference shareholders, are to be considered for calculation of the return to equity shareholders. It is not important, whether the profits are distributed to the equity shareholders or left in the firm as retained earnings. The profitability of a firm can be analyzed from the point of view of owners in different perspectives, as follows:
(A) Return on Investment
1. Return on Total Assets: ‘Total assets’ is the total amount appearing on the assets side of the balance sheet. However, in calculating total assets, fictitious assets like preliminary expenses, accumulated losses and discount on issue of shares are to be excluded. However, intangible assets like goodwill, patents and trademarks are to be included. Reason is these intangible assets contribute for the development of sales and business, while the fictitious assets do not add anything for the growth in business.
When return on investment is calculated on total assets, it is called ROTA. Total assets are related to operating profit. Operating profit is EBIT, in the absence of other income. EBIT is arrived at by adding financial charges (interest etc.) and tax to net operating profit. By this, we are separating financing effect from the operating effect. The formula is
2. Return on Capital Employed: Another way to calculate return on investment is through capital employed or net assets.
Capital employed can be calculated in two ways: Capital Employed = Net Worth + Long-term Borrowings OR = Net Fixed Assets + Current Assets – Current Liabilities
Return on net assets is called RONA. As net assets are equal to capital employed, the terms RONA and ROCE indicate the same. This ratio indicates the overall efficiency of business, before tax. The formula for calculation is
Interpretation:
1. ROI (ROTA and RONA) measure the overall efficiency of business.
2. The owners are interested in knowing the profitability of the firm, in relation to the total assets and amount invested in the firm. A higher percentage of return on capital employed will satisfy the owners that their funds are profitably utilized.
3. It indicates the efficiency of the management of various departments as funds are kept at its disposal for making investment in assets
4. Inter-firm comparison would be useful. Both the ratios of a particular firm should be compared with the industry average or its immediate competitor to understand the efficiency of the management in managing the assets, profitably. So, a higher rate of return on capital employed, without comparison, does not imply that the firm is managed, efficiently. Once a comparison is made with other firms, having similar characteristics, in the same industry, a fair conclusion is possible.
(B) Return on Equity
In the real sense, equity shareholders are the real owners of the company. They assume the risk in the firm. Preference shareholders enjoy fixed rate of dividend and preference for payment of dividend, before dividend is distributed to equity shareholders. Similarly, in the event of the liquidation of the company, preference share capital has to be repaid first, before refunding to equity shareholders. Net profits after tax, after dividend is paid to preference shareholders, entirely belong to the equity shareholders. Equity shareholders would be interested to know what their real return is on the funds invested. This ratio for return on equity is calculated as under:
Equity shareholders’ funds are equity share capital, accumulated reserves (both general reserves and capital reserves), share premium and balance in profit and loss account less accumulated losses, if any.
Preference shareholders are not to be included as the dividend due to them has already been deducted from profits after tax.
Interpretation:
1. ROE indicates how well the firm has used the resources of owners.
2. Earning a satisfactory return is the most desirable objective of a business. This ratio is of greatest interest to the management as it is their responsibility to maximize the owners’ welfare.
3. This ratio is more meaningful to equity shareholders as they are interested to know their return. Interpretation of this ratio is similar to return on investments. Higher the ratio, better it is to equity shareholders.
Amit: Uncle, Often I have heard one word i.e. EPS. What is EPS?
Uncle: Amit, EPS is Earnings per Share. The profitability of the equity shareholders can be measured, in other ways. One such measure is to calculate the earnings per equity share. The earnings per equity share is calculated by
Interpretation:
1. EPS simply shows the profitability of the firm per equity share basis.
2. EPS calculation, over the years, indicates how the firm’s earning power, per share basis, has changed over the years.
3. EPS of the firm is to be compared with the industry and its immediate competing firm to understand the relative performance of the firm
(D) Dividends per Share (DPS)
After payment of dividend to preference shareholders, balance net profit belongs to equity shareholders, whether distributed in the form of dividend or retained in business. Dividend per share is a measure of real cash income that is made available to i.e. distributed among equity shareholders as against the EPS, for companies do not normally distribute their entire EPS as dividend.
Dividend per share is calculated as under:
As such, a majority of the present and potential Investors would be interested in DPS rather than EPS.
(E) Dividend Pay-out Ratio or Pay-out Ratio
Dividend pay-out ratio is calculated to find out the proportion of dividend distributed out of earnings per share.
For example, if the firm has an EPS and DPS of Rs. 5 and Rs. 3 respectively, DP ratio is 3/5 i.e. 60%. So, the firm has distributed 60% of PAT (profits after tax) as dividend among its shareholders. So, the ratio is calculated by
(F) Dividend Yield Ratio
Shareholders are the true owners, interested in the earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to evaluate the relationship between the dividends paid per share and the market value of the share.
(G) Price Earnings Ratio
P/E Ratio is used to determine how much investors are willing to pay for a stock relative to the company’s earning. This is the ratio that establishes the relationship between the market price of a share and its EPS. This ratio indicates the number of times the earnings per share is covered by its market price. The ratio is calculated as per the following formula:
Can you give us example and explain this ratio?
Sure Let’s take two companies. Company Alfa and Company Beta.
The price earnings ratio indicates investors’ judgment or expectations about the firm’s future performance. This ratio is widely used by the security analysts and investors to decide whether to buy or sell the shares of a particular company, at that price.
P E Ratio tells you how to cheap or expensive a company’s stock is. It is the number of times investors must pay for the company’s current earnings. For example, assume that the share price of a company is Rs.80. If its EPS is, say Rs. 5, its P/E is 16. So investors are willing to pay 16 times for every rupee of the company’s earnings.
This is all about ratio analysis.
Now Remember, Ratios are only indicators, not end in themselves: They identify the trends, shift in trends or other factors. They are not to be accepted on their face value. They are helpful in identifying the problem areas of a firm. They lead way for further investigation and meaningful conclusion. They are only the means to achieve a particular end. By themselves, they do not give final results.
