Ratio Analysis: Liquidity, Profitability, Activity and Solvency

A bank has two borrowers. One earns ₹4,20,000 a year, the other ₹9,00,000. Which is safer? The answer depends on how much each owns, owes and sells, and a ratio puts those figures side by side.

One company for every ratio. This chapter uses Kaveri Auto Parts, a small maker in Coimbatore. Every ratio that follows comes from these figures.

The opening balances are inventory ₹6,00,000, debtors ₹4,00,000 and creditors ₹4,00,000. Kaveri has 1,00,000 shares, and its market price is ₹63.

How to read a ratio. A number means little alone. Compare it three ways: with the firm’s own past years (trend), with similar firms (inter-firm), and with a standard such as 2:1 for the current ratio.

Don’t treat a rule of thumb as a law. The ‘ideal’ current ratio of 2:1 and quick ratio of 1:1 are conventions. A supermarket that sells for cash and pays suppliers on credit runs safely on less. What matters is the pattern in your industry.

Where it breaks. Ratios use past, accrual-based figures, and firms use different accounting policies. A year-end snapshot can be dressed up. Inflation distorts comparisons over time. A ratio shows that something looks odd, not why.

For exams. Know the four families and one formula for each ratio, and which statement each figure comes from.

Liquidity, profitability, activity, solvency: short-term, earning, efficiency, long-term.

Firm A earns ₹50,000 on sales of ₹5,00,000. Firm B earns ₹1,00,000 on sales of ₹50,00,000. B’s profit is twice as large, but is B the more efficient? Set against sales, A keeps 10% and B keeps 2%.

What the analysis is for. It shows the present and likely future earning power of a business, the efficiency of the whole firm and of its departments, its short-term and long-term solvency, and it makes comparison with other firms easy.

Advantages. Ratios make statements easier to read. They show trends from year to year, which helps forecasting. They support control and decision-making, and they show the links between different parts of the business.

Limitations. Ratios leave out qualitative factors, such as the quality of management or the loyalty of customers, because they are built on money figures. A single year’s ratio says little, and trends over several years say more. And if the accounts are defective or the firm leaves things out on purpose, the ratios will be wrong in the same way.

Don’t treat a good ratio as proof of a good firm. A ratio can be right and still mislead. Different firms use different accounting policies, and a year-end snapshot can be arranged to look better. Use ratios to find questions to ask, and look for the answer in the business.

Where it breaks. Ratios are only as good as the data. Inflation distorts comparisons across years. A firm that is a mix of several industries has no single sensible benchmark.

For exams. Know both classifications with an example of each, and be ready to list advantages and limitations.

Where the figures come from, and what the ratio tests.

Kaveri has ₹18,00,000 in current assets and ₹8,00,000 in current liabilities. Can it pay everything it owes in the next year, and could it pay this week if suppliers called their bills?

Kaveri’s figures.

Kaveri passes the usual tests. Even without selling any stock it has ₹1.25 of liquid assets for each ₹1 due. Half the amount due could be met from cash alone.

Don’t confuse the quick ratio with the current ratio. The quick ratio leaves out inventory because stock can take months to turn into cash, and may sell below cost. A firm with a healthy current ratio but a weak quick ratio is relying on its stock being sold.

Where it breaks. A very high liquidity ratio is not good news by itself. It may mean cash lying idle, slow-moving stock or debtors who do not pay. Ratios taken on one day can also be improved by year-end window dressing, such as paying creditors just before the date.

Two related points. Strictly, quick assets also leave out prepaid expenses, and quick liabilities leave out a bank overdraft that is a permanent part of financing. The stock-working capital ratio is closing stock ÷ working capital: ₹8,00,000 ÷ ₹10,00,000 = 0.8, so stock is 80% of Kaveri’s working capital. The nearer it is to 100%, the more working capital rests on selling stock.

For exams. Learn the three formulas and the 2 : 1 and 1 : 1 benchmarks, and remember that higher means better short-term payment capacity, up to a point.

Current: all current assets. Quick: leave out stock. Cash: only cash.

Kaveri sold ₹50,00,000 and kept ₹4,20,000. Is that a good year? It depends on what it earned from each rupee of sales, and from each rupee its owners and lenders put in.

Out of every ₹100 of sales Kaveri keeps ₹30 after the cost of goods and ₹8.4 at the end. Each ₹100 of assets earns ₹10.5, and each ₹100 the owners have in the business earns ₹17.5. ROE is higher than ROA because part of the assets are paid for with debt.

A market ratio. Earnings per share is net profit ÷ number of shares: ₹4,20,000 ÷ 100,000 = ₹4.20. The price-earnings (P/E) ratio is the share price ÷ earnings per share: ₹63 ÷ ₹4.20 = 15. It shows how many rupees investors pay for each rupee of earnings. A higher ratio signals more confidence in future earnings.

Don’t mix up the denominators. ROA divides by all assets, ROE only by the owners’ funds. Gross and net profit ratios both divide by net sales. If a question says ‘return on capital employed’ it uses yet another denominator, so read it.

Where it breaks. A high margin on few sales can earn less than a thin margin on many. Profit is an accrual figure and can be moved between years. ROE can be raised by borrowing more, which also raises the risk; a high ROE with high debt is not a safe one.

For exams. Recall the four formulas and the sequence gross profit, net profit, return on assets, return on equity. The P/E ratio is often asked.

Gross, net, assets, equity: the denominator changes from sales to what is invested.

Kaveri’s gross profit is ₹15,00,000 but its operating profit is ₹7,00,000. Where did ₹8,00,000 go, and how much does it earn on the long-term money in the business?

The two add to 100%. Of each ₹100 of sales, ₹86 goes on running the business and ₹14 is operating profit, before interest and tax. A lower operating ratio means more is left to pay interest, tax and dividends and to build reserves.

The same ₹32,00,000 is also fixed assets ₹22,00,000 plus working capital ₹10,00,000. Kaveri earns about ₹22 before interest and tax on each ₹100 of long-term money. Compared with a borrowing rate of 10%, that is a good margin.

Earnings per share, again. EPS is the profit available to equity shareholders divided by the number of equity shares. Profit available is profit after tax less any preference dividend. If Kaveri also paid ₹20,000 of preference dividend, EPS would be (₹4,20,000 − ₹20,000) ÷ 100,000 = ₹4.00.

Don’t read a fall in EPS as a fall in profit. If Kaveri issued one bonus share for every four held, its shares would rise from 100,000 to 125,000. Profit is unchanged, but EPS falls from ₹4.20 to ₹3.36. The firm has not become less profitable; its profit is just spread over more shares.

Where it breaks. ROCE uses profit before interest and tax, so it can look good for a firm that pays heavy interest. The definition of capital employed differs between books, so say which one you use. The operating ratio treats all costs as one lump, and does not show which cost rose.

For exams. Learn the formulas, and that operating ratio and operating profit ratio add to 100%. Know that ROCE is also called return on investment (ROI).

Operating ratio plus operating profit ratio makes 100.

Kaveri holds ₹8,00,000 of stock and is owed ₹6,00,000 by customers. If both sit for a year, the money is idle. How fast do they turn into sales and cash?

Averages. Kaveri’s average inventory is (₹6,00,000 + ₹8,00,000) ÷ 2 = ₹7,00,000. Average debtors are ₹5,00,000, and average creditors ₹4,50,000. Credit purchases are cost of goods sold plus the rise in stock, ₹35,00,000 + ₹2,00,000 = ₹37,00,000, taking all purchases as on credit.

Kaveri collects in about 46 days and pays in about 44 days, so customers and suppliers are treated about the same. Stock sits for 73 days. To cut the cash tied up, it would first work on stock.

Don’t use the wrong figure on top. Inventory turnover uses cost of goods sold, not sales, because stock is valued at cost. Debtors turnover uses credit sales only, since cash sales never create a debtor. Using total sales makes collection look faster than it is.

Fixed assets turnover. Net sales ÷ net fixed assets shows how many rupees of sales each rupee of fixed assets produces. Taking Kaveri’s non-current assets of ₹22,00,000 as its net fixed assets, it is ₹50,00,000 ÷ ₹22,00,000 = 2.27 times. A higher figure means the plant is used harder.

A worked question. Opening stock is ₹58,000, closing stock is ₹58,000 + ₹4,000 = ₹62,000, sales are ₹6,40,000, and gross profit is 25% on cost. Cost of goods sold is the sales × 100/125 = ₹5,12,000. Average stock is ₹60,000. Stock turnover = ₹5,12,000 ÷ ₹60,000 = 8.53 times. The catch is that 25% on cost is only 20% of sales.

The average payment period. 365 ÷ creditors turnover. It is the average credit period used: for Kaveri about 44 days. (Some books misprint this as debtors turnover; the formula uses the creditors figure.)

Where it breaks. A high turnover is not always better: very fast stock turnover may mean frequent stock-outs, and slow payment of creditors may harm supplier trust. Seasonal firms need averages over several points in the year, not two balance-sheet dates.

For exams. Remember the four formulas and the line ‘higher turnover generally means efficient use’. Convert turnover to days by dividing 365 by the ratio.

Stock on cost, debtors on credit sales, creditors on credit purchases, assets on sales.

Kaveri owes ₹10,00,000 to lenders. Whether that is comfortable depends on how much the owners have in the business and on whether profits cover the interest.

Lenders have put in 42 paise for every rupee the owners have, and they finance a quarter of the assets. Operating profit is seven times the interest, so a fall of up to six-sevenths in operating profit would still leave the interest covered.

Don’t confuse the debt ratio with debt-to-equity. The first divides by total assets, the second by owners’ equity only. Debt-to-equity is always the larger of the two (unless there is no debt). Many sources also differ on what to count as debt, so always check whether short-term borrowings are included.

Three more tests. The proprietary ratio is shareholders’ funds ÷ total assets: ₹24,00,000 ÷ ₹40,00,000 = 0.6, so owners paid for 60% of the assets. The capital gearing ratio is fixed-interest and fixed-dividend funds ÷ equity funds: ₹8,00,000 ÷ ₹24,00,000 = 0.33. The total assets to debt ratio is total assets ÷ long-term debt: ₹40,00,000 ÷ ₹8,00,000 = 5 times, so each rupee of long-term debt is covered five times over by assets.

Which debt? Some books take only long-term debt: ₹8,00,000 ÷ ₹24,00,000 = 0.33, against 0.42 when short-term borrowings are included. Many treat 2 : 1 as the most that is prudent, except for a few businesses. Always say which definition you use.

Where it breaks. Debt is not bad in itself: borrowing at 10% to earn 18% raises the owners’ return. What matters is whether the firm earns well above its interest rate and has steady profits. A cyclical firm with the same ratios is riskier than a steady one.

For exams. Recall the three formulas and that lower debt ratios mean lower risk, higher interest coverage means safer interest.

Debt against owners’ money, debt against assets, profit against interest.