Ratio Analysis
Ratio Analysis
Introduction
Ratio analysis is a powerful tool for evaluating the financial performance and health of an entity. By expressing relationships between financial statement items as ratios, bankers can assess a borrower's liquidity, profitability, solvency, and efficiency. This is a calculation-heavy and high-weightage topic in the JAIIB exam.
Categories of Financial Ratios
| Category | Measures | Key For |
|---|---|---|
| Liquidity Ratios | Short-term solvency | Can the firm pay current obligations? |
| Profitability Ratios | Earning capacity | Is the firm profitable? |
| Leverage/Solvency Ratios | Long-term solvency | Can the firm meet long-term debt? |
| Efficiency/Activity Ratios | Asset utilisation | How well are assets being used? |
| Market Ratios | Investor perspective | What is the market's valuation? |
Liquidity Ratios
1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
| Ideal | Interpretation |
|---|---|
| 2:1 | Adequate liquidity to meet short-term obligations |
| > 2:1 | Excess idle funds |
| < 2:1 | Potential liquidity stress |
2. Quick Ratio (Acid Test Ratio)
Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities
| Ideal | Interpretation |
|---|---|
| 1:1 | Can meet obligations without selling inventory |
Note: Inventory is excluded because it is the least liquid current asset
Worked Example
Current Assets = Rs 15,00,000 (including Inventory Rs 5,00,000) Current Liabilities = Rs 9,00,000
- Current Ratio = 15,00,000 / 9,00,000 = 1.67:1
- Quick Ratio = (15,00,000 - 5,00,000) / 9,00,000 = 10,00,000 / 9,00,000 = 1.11:1
Profitability Ratios
1. Gross Profit Ratio
GP Ratio = (Gross Profit / Net Sales) x 100
Gross Profit = Net Sales - Cost of Goods Sold
2. Net Profit Ratio
NP Ratio = (Net Profit / Net Sales) x 100
3. Operating Profit Ratio
Operating Profit Ratio = (Operating Profit / Net Sales) x 100
Operating Profit = Gross Profit - Operating Expenses (excludes interest, tax, non-operating items)
4. Return on Equity (ROE)
ROE = (Net Profit / Shareholders' Equity) x 100
Measures return generated on equity capital invested.
5. Return on Assets (ROA)
ROA = (Net Profit / Total Assets) x 100
Measures how efficiently assets are used to generate profit.
6. Return on Capital Employed (ROCE)
ROCE = (EBIT / Capital Employed) x 100
Capital Employed = Total Assets - Current Liabilities = Equity + Long-term Debt
7. Earnings Per Share (EPS)
EPS = Net Profit (PAT) / Number of Equity Shares
Worked Example
Revenue = Rs 10,00,000; COGS = Rs 4,00,000; Operating Expenses = Rs 2,00,000 Interest = Rs 1,00,000; Tax Rate = 30%; Equity Shares = 50,000
- Gross Profit = 10,00,000 - 4,00,000 = Rs 6,00,000
- GP Ratio = (6,00,000 / 10,00,000) x 100 = 60%
- Operating Profit = 6,00,000 - 2,00,000 = Rs 4,00,000
- EBIT = Rs 4,00,000
- EBT = 4,00,000 - 1,00,000 = Rs 3,00,000
- PAT = 3,00,000 x 70% = Rs 2,10,000
- NP Ratio = (2,10,000 / 10,00,000) x 100 = 21%
- EPS = 2,10,000 / 50,000 = Rs 4.20
Leverage/Solvency Ratios
1. Debt-Equity Ratio
Debt-Equity Ratio = Total Debt / Shareholders' Equity
| Ideal | Interpretation |
|---|---|
| < 2:1 | Conservative financing |
| > 2:1 | Higher financial risk |
Note: When an asset is acquired on lease, it stays off the balance sheet, so the debt-equity ratio remains unaffected compared to purchasing with borrowed funds.
2. Interest Coverage Ratio (ICR)
ICR = EBIT / Interest Expense
Measures the firm's ability to pay interest from operating earnings.
| Value | Interpretation |
|---|---|
| > 3 | Comfortable |
| 1-3 | Marginal |
| < 1 | Cannot cover interest from earnings |
3. Debt Service Coverage Ratio (DSCR)
DSCR = (Net Profit + Depreciation + Interest) / (Interest + Principal Repayment)
Critical for banks when assessing loan proposals. DSCR > 1.5 is generally considered adequate.
Worked Example
EBIT = Rs 4,00,000; Interest = Rs 1,00,000; Total Debt = Rs 8,00,000; Equity = Rs 5,00,000
- Debt-Equity Ratio = 8,00,000 / 5,00,000 = 1.6:1
- ICR = 4,00,000 / 1,00,000 = 4 times
Efficiency/Activity Ratios
1. Inventory Turnover Ratio
Inventory Turnover = COGS / Average Inventory
Higher ratio = faster inventory movement = better efficiency
2. Debtors Turnover Ratio
Debtors Turnover = Net Credit Sales / Average Debtors
3. Average Collection Period
Collection Period = 365 / Debtors Turnover Ratio (in days)
4. Creditors Turnover Ratio
Creditors Turnover = Net Credit Purchases / Average Creditors
5. Asset Turnover Ratio
Asset Turnover = Net Sales / Total Assets
6. Working Capital Turnover
Working Capital Turnover = Net Sales / Working Capital
Banking-Specific Ratios
| Ratio | Formula | Significance |
|---|---|---|
| Net Interest Margin (NIM) | (Interest Earned - Interest Expended) / Average Earning Assets | Core profitability |
| Cost to Income Ratio | Operating Expenses / Operating Income | Operational efficiency |
| CASA Ratio | (Current A/c + Savings A/c Deposits) / Total Deposits | Low-cost fund proportion |
| Credit-Deposit Ratio | Total Advances / Total Deposits | Lending aggressiveness |
| Gross NPA Ratio | Gross NPAs / Gross Advances | Asset quality |
| Net NPA Ratio | Net NPAs / Net Advances | True asset quality |
| Capital Adequacy Ratio (CRAR) | (Tier 1 + Tier 2 Capital) / Risk Weighted Assets | Capital strength |
| Provision Coverage Ratio | Provisions / Gross NPAs | Provision adequacy |
DuPont Analysis
DuPont breaks down ROE into three components:
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
= (PAT/Sales) x (Sales/Total Assets) x (Total Assets/Equity)
This helps identify whether profitability, efficiency, or leverage is driving returns.
Limitations of Ratio Analysis
- Window dressing: Firms may manipulate figures at year-end
- Different accounting policies: Comparison becomes difficult
- No industry standard: "Ideal" ratios vary by industry
- Historical data: Ratios are backward-looking
- Ignores qualitative factors: Management quality, market conditions
- Inflation effects: Distorts comparisons over time
Key Points to Remember
- Current Ratio = Current Assets / Current Liabilities — ideal 2:1
- Quick Ratio excludes inventory — ideal 1:1
- Debt-Equity Ratio = Total Debt / Equity — lease assets keep it unaffected
- ICR = EBIT / Interest — measures ability to service debt
- DSCR > 1.5 is generally adequate for loan assessment
- EPS = PAT / Number of Shares
- ROE = PAT / Equity; ROA = PAT / Total Assets; ROCE = EBIT / Capital Employed
- NIM is the core profitability measure for banks
- CASA Ratio indicates proportion of low-cost deposits
- Gross NPA Ratio = Gross NPAs / Gross Advances
- DuPont: ROE = Margin x Turnover x Leverage
- Ratios are most useful when compared across time periods and industry peers