 A ratio is a statistical yardstick that provides a

measure of the relationship between two

variables or figures.
 Ratio allow us to compare companies across ,
big and small, to identify their strength and
weaknesses.
 Ratios reduce the impact of firm size.
 Liquidity Ratio
 Leverage ratio./Solvency ratio
 Turn over ratio/Activity ratio
 Profitability ratio
 Valuation ratio
 Liquidity refer to the ease and speed with
which an assets can be converted into cash.
 Liquidity has two dimension , ease of
conversion and loss of value.

 Shows ability of company to pay its current/

short term financial obligations.
 It has two types
 i) Current Rtaio ii)Quick ( Acid-Test) Ratio
 Indicates whether current liabilities are
adequately covered by current assets
 Measures safety margin available for short
term creditors.
 CR = Current assets/ Current liabilities
 CR = 681/399 = 1. 71
 Industry average. 2

 If Net Working Capital is to be positive, CR

>1
 Used to examine whether firm has adequate cash or cash
equivalents to meet current obligations without resorting to
liquidating non cash assets such as inventories

 Measures position of liquidity at a point of time

 QR = Quick Assets / Current Liabilities

 Quick assets = Current assets – ( inventories + prepaid

expenses)
 = 681–(355+64) = 262
 Current liabilities = 399
 n QR = 262/399 = 0.66
 Industry average. 02
 As a thumb rule ideal QR = 1; should not be less than 1
 LEVERAGE RATIOS
 Shows dependence of firm on outside long term
finance
 Shows long term financial solvency & measures
firm’s ability to pay interest & principle regularly
when due
 To assess extent to which the firm borrowed
money and funds supplied by owners;
 Use of debt finance ,Companies whose EBIT <=
Interest payments are risky
14-7

Financial leverage results from the difference between

the rate of return the company earns on investments
in its own assets and the rate of return that the
company must pay its creditors.

Fixed rate of
Return on return on Positive
investment in > borrowed = financial
assets funds leverage

Return on Fixed rate of Negative

investment in < return on = financial
assets borrowed leverage
funds
 Debt - Equity ratio
 Debt - Total fund ratio
 Debt - Assetsratio
 Interest coverage ratio
 Liability coverage ratio
 Measures relative proportion of debt & equity in
financing assets of a firm
 Company can have good current ratio and
liquidity position, however liquidity may have
come from long term borrowed
 funds, the repayment of which along with
interest will put liquidity under pressure
 DER = Long term debt / Share holders funds
 Creditors would like this to be low; Lower
ratio implies larger credit cushion (margin of
protection to creditors)
Expected DER of 2:1 in respect of SMEs
 Debt (loans) = Secure loans + Unsecure
loans
 = 151+30=181
 Share holders funds = (equity+ preference
capital + res & surplus – fictitious assets &
accumulated losses not written off )
 = 120+50+215 = 385
 n DER = 181/385 = 0.47 = (0.47:1)
 Creditors are providing Rs 0.47 financing for
each rupee provided by shareholders
 Debt - Assets ratio = Debt / Net assets
Debt = 181
Net assets (less fictitious assets & losses) =
930
Ratio = 181/930 = 0.19
19% of the firms assets are financed with
debt (of
various types).
Shows coverage provided by the assets to
total debt
 Gives ability of company to pay back long term loans along with
interest or other charges from generation of profit from its
operations.

 Interest coverage ratio = EBIT / Debt interest

EBIT = 143
Interest = 29+4 = 33
Ratio = 143/33=4.33
EBIT should be 6 – 7 times of debt interest
Shows margin of cover to lenders;

 This is the most common measure

of a company’s ability to provide
protection for its long-term
creditors. A ratio of less than 1.0
is inadequate.
 Calculated to determine time a company would
take
to pay off all its liabilities from internally
generated
funds
Assumes that liabilities will not be liquidated
from
additional borrowings or from sale of assets
LCR = Internally generated funds / Total
liabilities
Internally gen funds = Equity + Pref + R&S = 385
Total liabilities = 965
LCR = 385/965 = 0.399
 Allows to examine whether total amount of each type
of asset a company owns is reasonable, too high or too
low in light of current and forecast operating needs
In order to purchase / acquire assets, companies
need to borrow or obtain Capital from elsewhere :-
More assets acquired implies high int and low profits
Lesser assets implies operations not as efficient as
possible
Activity turn over ratios used to assess efficiency
with
 Inventory turnover ratio
• Average collection period
• Fixed assets turn over ratio
14-15

Inventory Cost of Goods Sold

Turnover = Average Inventory
This ratio measures how many times a
company’s inventory has been sold
and replaced during the year.

If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of inventory.
14-16

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

A ratio of 12 .7 times indicates inventory

turned over 12.73 times in a year
14-17

Average 365 Days

=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to sell the
entire inventory.
14-18

Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
14-19

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,
how many days it takes to collect
an account receivable.
Represents duration a
company must wait after
making
sales, before it actually
receives cash from its
customers
 Measures effectiveness of utilization of fixed
assets by company
 Used to compare fixed assets utilization of two
firms .

 Fixed assets turnover ratio: Sales/ net fixed

asset
$3000/$1000= 3.00 time
 Total assets turnover ratio= sale/ total assets

 = $3000/$2000
 = 1.5
 Industry average = 1.8
 Profitability ratios indicate
• Company's profitability in relation to other
companies
• Internal comparison with last yrs profits
•Managements effectiveness as shown by
returns generated on sales and investments
14-23

Return on Net Income + [Interest Expense × (1 – Tax Rate)]

=
Total Assets Average Total Assets

Return on $53,690 + [$7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2

Adding interest expense back to net income

enables the return on assets to be compared for
companies with different amounts of debt or
over time for a single company that has
changed its mix of debt and equity.
14-24

Return on Common = Net Income – Preferred Dividends

Stockholders’ Equity Average Stockholders’ Equity

Return on Common = $53,690 – $0 = 25.91%

Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company used the owners’ investments
to earn income.
 A valuation ratio is a measure of how cheap or
expensive a security (or business) is, compared
to some measure of profit or value. A valuation
ratio is calculated by dividing a measure of
price by a measure of value, or vice-versa.
 Represents total earnings of a company
available for
distribution among equity shareholders
Evaluates performance of company shares
over a period of
time
EPS = Net profit available for equity
shareholders / No of
Equity shares
14-27

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 – $0 = $2.42

(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
14-28

Price-Earnings Market Price Per Share

=
Ratio Earnings Per Share

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

A higher price-earnings ratio means that

investors are willing to pay a premium for
a company’s stock because of optimistic
future growth prospects.
14-29

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current earnings

being paid out in dividends. Investors seeking
dividends (market price growth) would like this
ratio to be large (small).
14-30

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in terms

of cash dividends, on the current market
price of the stock.
14-31

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common stock
if all assets were sold at their balance sheet carrying
amounts after all creditors were paid off.
14-32

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does not
equal the market value per share of $20. This is
because the market price reflects expectations about
future earnings and dividends, whereas the book
value per share is based on historical cost.
 Refers to overall market risk which a security is carrying
and which cannot be diversified

Responsiveness of share price of a company with respect
to overall market movement

If over a period of time, market has given a return of 20%;
individual share of company ‘A’ has given return of 10%;
Beta of A = 10 / 20 = 0.5

If investor is risk averse, should invest in stocks with low
Beta; Even if market falls by drastic amount his investment
will not take that much hit