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Financial Ratios

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Types of Ratios
 Liquidity ratios
 Leverage ratios
 Efficiency ratios
 Profitability ratios
 Market value ratio

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 Liquidity
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Definition
Liquidity ratios are financial ratios that measure a
company’s ability to repay both short- and long-term
obligations.
Use of Liquidity ratios
Liquidity ratios are commonly used by prospective creditors
and lenders to decide whether to extend credit or debt,
respectively, to companies.
Common liquidity ratios include the following:
 Current ratio
 Acid-test ratio
 Absolute Liquid Ratio
 Cash ratio
 Operating cash flow ratio
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Click toRatio
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The current ratio measures a company’s ability to pay off short-term

liabilities with current assets.

Theoretically, a high current ratio is a sign that the company is sufficiently

liquid and can easily pay off its current liabilities using its current assets. Thus a company with a
current ratio of 2.5X is considered to be more liquid than a company with a current ratio of 1.5X. The
logic is that a company with a current ratio of 2.5X has a greater comfort level when it comes to
servicing its current liabilities using its current assets.

Ideal Current Ratio = 2:1

By definition, a company with a higher current ratio should be more

attractive from an investment perspective compared to a company with
a lower current ratio? But, that is not the case in reality! Let us 4 4
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Current RatioMaster title style

 Let us assume that the company is having problems recovering its dues from its debtors and the debtor cycle is
negative and that may be the reason for a high current ratio. That is not a healthy sign from the point of view of
working capital management.
 It is possible that the company is having too much of working capital invested in inventories.

 The business could be having an unfavorable working capital cycle wherein the debtors are paying after a credit period
but the payout to creditors is happening upfront. This may overstate the current ratio due to low levels of creditor
payables.
A classic case of a high current ratio was Arvind Mills in the mid 1990s. 

It had boasted of a current ratio of 6:1 and was just coming out its aggressive expansion
plans in denim since the late 1980s. Denim, where Arvind had invested heavily into
enhancing capacity was going through a downturn. Inventories were piling up as lower
cost denims were being manufactured in other Asian countries. By 1998 Arvind Mills
found itself in a situation where debt was mounting, inventories were piling up and denim
demand was in a sharp downturn. The result was that Arvind was almost thrust into the
throes of bankruptcy by 1998-99.
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 Acid test Ratio
ClickThe acid-test
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ability to pay off short-term
liabilities with quick assets. Ideal = 1:1

Absolute Liquid Ratio 

Absolute Liquid Ratio is a type of liquidity ratio that is calculated to analyze the short term
solvency or financial position of the firm. Ideal 1:2

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Liquidity Master title style
Ratios

Cash ratio 
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Operating cash flow ratio 

The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the
cash generated in a given period:

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Leverage Master Ratios
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Definition
Leverage ratios measure the amount of capital that comes from debt. In other words,
leverage financial ratios are used to evaluate a company’s debt levels.
Uses of Leverage ratios
Leverage ratios are used to measure solvency of a company, its financial structure
and how it operates with the given fund (equity and debt). It is used by creditors,
investors as well as the internal management to evaluate the company's growth, ability
to clear all dues/debts/interests.
Common leverage ratios include the following:
 Debt ratio
 Debt to equity ratio
 Interest coverage ratio
 Debt service coverage ratio

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Debt ratio 
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The debt ratio measures the relative amount of a company’s assets that are
provided from debt
Ideal Debt Ratio
In general, many investors look for
a company to have a debt ratio
between 0.3 and 0.6.From
a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of
0.6 or higher makes it more difficult to borrow money. 

Debt to equity ratio 

The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity.
Ideal Debt to equity Ratio
Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered
risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this
company would be considered extremely risky.
 

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Interest coverage ratio 
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The interest coverage ratio shows how easily a company can pay its interest
expenses.
Ideal Interest coverage Ratio
Generally, an interest coverage ratio of at least two (2) is considered the minimum
acceptable amount for a company that has solid, consistent revenues. Analysts prefer to see
a coverage ratio of three (3) or better.

Debt service coverage ratio

The debt service coverage ratio reveals how easily a company can pay its debt obligations.
Ideal Debt service coverage ratio
A debt service coverage ratio of 1 or above indicates that a company
is generating sufficient operating income to cover its annual debt and
interest payments.
As a general rule of thumb, an ideal ratio is 2 or higher.

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Efficiency
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Definition
Efficiency ratios, also known as activity financial ratios, are used to
measure how well a company is utilizing its assets and resources.

Uses of Efficiency ratios

Efficiency ratios compare what a company owns to its sales or profit
performance and inform investors about a company's ability to use what
it has to generate the most profit possible for owners and shareholders.

Common efficiency ratios include:

 Asset turnover ratio 
 Inventory turnover ratio
 Receivables turnover ratio 
 Days sales in inventory ratio 

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Asset
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The asset turnover ratio measures a company’s ability to generate sales from assets

Ideal Asset turnover ratio

In the retail sector, an asset

turnover ratio of 2.5 or more
could be considered good, while a
company in the utilities sector is more likely to aim for an asset turnover ratio that's between
0.25 and 0.5.
 

Inventory turnover ratio 

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a
given period

Ideal Inventory turnover ratio

A good inventory turnover ratio is between
5 and 10 for most industries, which indicates
that you sell and restock your inventory
every 1-2 months. This ratio strikes a good balance
between having enough inventory on hand and not
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having to reorder too frequently.
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Accounts receivable turnover ratio
The accounts receivable turnover ratio measures how many times a company can
turn receivables into cash over a given period.
 

Days sales in inventory ratio 

The days sales in inventory ratio measures the
average number of days that a company holds
on to inventory before selling it to customers.

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Profitability Ratios
Definition

Profitability ratios measure a company’s ability to generate income relative to

revenue, balance sheet assets, operating costs, and equity.

Uses of Profitability ratio

Profitability ratio is used by investors to evaluate the company's ability to

generate income as compared to its expenses and other cost associated with
the generation of income during a particular period. This ratio represents the
final result of the company.

Common profitability financial ratios include the following:

 Gross margin ratio 

 Operating margin ratio 
 Return on assets ratio
 Return on equity ratio 

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Gross
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The gross margin ratio compares the gross profit of a company to its net sales to
show how much profit a company makes after paying its cost of goods sold

Ideal Gross margin ratio = 65%

Operating margin ratio 

The operating margin ratio compares the operating income of a company to its net
sales to determine operating efficiency

Ideal Operating margin ratio

For most businesses, an operating margin higher
than 15% is considered good. It also helps to look at
trends in operating margin to see if past years indicate
that operating margin is going up or down.
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Return on assets
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The return on assets ratio measures how efficiently a company is using its assets to
generate profit

Ideal Return on assets ratio

An ROA of 5% or better is typically considered

a good ratio while 20% or better is considered
great. In general, the higher the ROA, the more efficient the company is at generating profits.
 

Return on equity ratio 

The return on equity ratio measures how efficiently a company is using its equity to generate profit

Ideal Return on equity ratio

ROE is especially used for comparing the performance
of companies in the same industry. As with return on capital,
a ROE is a measure of management's ability to generate income
from the equity available to it. ROEs of 15–20% are generally
considered good.
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Market
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Definition

Market value ratios are used to evaluate the share price of a company’s
stock.

Uses

Market value ratios are used to evaluate the current share price of a publicly-

held company's stock. These ratios are employed by current and potential
investors to determine whether a company's shares are over-priced or under-
priced.

Common market value ratios include the following

 Book value per share ratio

 Dividend yield ratio 
 Earnings per share ratio
 Price-earnings ratio  17
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Book value per share ratio

The book value per share ratio calculates the per-share value of a company based on the
equity available to shareholders:

Book value per share ratio = (Shareholder’s equity –

Preferred equity) / Total common shares outstanding
 

Dividend yield ratio

The dividend yield ratio measures the amount of dividends attributed to shareholders
relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

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Earnings per share ratio

The earnings per share ratio measures the amount of net income earned for each share
outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

Price-earnings ratio 
The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share

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Thank You

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