Quick Practice: Ratio Analysis Questions (New Ratio: Puppet Ability Ratio).

Welcome to the NISM series, where we break down essential financial concepts. This guide focuses on Ratio Analysis, a crucial tool for understanding a company's financial health. We'll cover key formulas, their calculations, and what they tell us about a business.

1. Profitability Ratios: How Well is the Company Earning?

Profitability ratios measure a company's ability to generate revenue and profit from its operations. Generally, a higher ratio indicates better profitability. Consistent profits often lead to an increase in share price.

a. Gross Profit Margin Ratio

This ratio shows the percentage of revenue left after deducting the cost of goods sold.

• Formula: (Gross Profit / Net Sales) * 100

• How to Calculate Gross Profit:

  • Gross Profit = Net Sales - Cost of Goods Sold (COGS)

• How to Calculate Cost of Goods Sold (COGS):

  • COGS = Opening Stock + Purchases + Factory-Level Expenses - Closing Stock

b. EBITDA Margin

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This ratio indicates a company's operating profitability before non-operating expenses and non-cash charges.

• Formula: (EBITDA / Net Sales) * 100

c. PAT (Profit After Tax) Margin

Also known as Net Profit Margin, this ratio shows the percentage of revenue remaining after all expenses, including taxes, have been deducted.

• Formula: (Profit After Tax (PAT) / Net Sales) * 100

• How to Calculate Net Sales:

  • Net Sales = Total Sales - GST - Sales Returns

d. Operating Profit Margin

This ratio reflects the profit a company makes from its core operations before interest and taxes.

• Formula: (Operating Profit / Net Sales) * 100

• How to Calculate Operating Profit:

  • Operating Profit can be found by deducting Office and Administration Expenses, Selling and Distribution Expenses, Financial Charges (like bank charges), and Depreciation & Amortization from Gross Profit.

e. Return on Assets (ROA)

ROA measures how efficiently a company is using its assets to generate profit.

• Formula: (Profit After Tax (PAT) / Total Assets) * 100

• Total Assets include both Fixed Assets and Current Assets.

f. Return on Equity (ROE)

ROE indicates how much profit a company generates for each rupee of shareholders' equity. This is a very important ratio from an exam perspective.

• Formula: (Profit After Tax (PAT) / Equity) * 100

• Equity is also known as Net Worth or Book Value.

g. Return on Capital Employed (ROCE)

ROCE measures the profitability of a company's capital, including both equity and debt.

• Formula: (EBIT / Total Capital Employed) * 100

2. Leverage Ratios: How Much Debt Does the Company Have?

Leverage ratios assess the extent to which a company uses debt to finance its assets.

a. Debt-to-Equity Ratio

This ratio compares a company's total debt to its total equity. It shows how much debt a company is using to finance its assets relative to the value of shareholders' equity.

• Formula: Debt / Equity

• Debt refers to Borrowed Capital (e.g., long-term loans).

• Equity refers to Owner's Capital.

• Interpretation: Some investors prefer zero-debt companies. A ratio of 0.2 means that for every 1 rupee of equity, there is 20 paisa of debt.

b. Interest Coverage Ratio

This ratio indicates a company's ability to meet its interest payment obligations. A higher ratio suggests the company can comfortably cover its interest expenses.

• Formula: EBIT / Interest Expenses

• Interpretation: If EBIT is ₹5,000 crore and interest expense is ₹1,000 crore, the ratio is 5 times. This means the company has 5 rupees of profit (before interest and tax) for every 1 rupee of interest expense.

3. Liquidity Ratios: Can the Company Meet Its Short-Term Obligations?

Liquidity ratios measure a company's ability to pay off its short-term liabilities with its short-term assets. These ratios are often compared with those of competitors within the same industry, as industry standards can vary.

a. Current Ratio

The current ratio indicates whether a company has enough short-term assets to cover its short-term liabilities.

• Formula: Current Assets / Current Liabilities

• Industry Standard: While a 2:1 ratio (2 rupees of current assets for every 1 rupee of current liability) was traditionally considered good in B.Com, it's not a universal standard. Always compare with industry peers.

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  What are Current Assets? 

  Assets that can be converted into cash within one year. Examples include:

  • Cash and Cash Equivalents (cash on hand, bank balance, short-term deposits)

  • Accounts Receivable (money owed by customers)

  • Inventory (raw materials, finished goods, work-in-progress)

  • Short-term Investments (marketable securities, treasury bills)

  • Prepaid Expenses (advance tax, advance rent, prepaid insurance)

  • Other Receivables (GST refunds, tax recovery, interest receivable)

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  What are Current Liabilities? 

  Liabilities that need to be paid within one year. Examples include:

  • Accounts Payable (money owed to suppliers)

  • Short-term Loans and Borrowings (overdraft, working capital loans)

  • Outstanding Expenses (salaries due, unpaid rent)

  • Unearned Revenue/Deferred Income (advance payments received for future services)

  • Current portion of long-term debt

  • GST and Income Tax liabilities

b. Quick Ratio (Acid-Test Ratio)

The quick ratio is a more conservative measure of liquidity, as it excludes inventory from current assets because inventory might not be easily convertible to cash in the short term.

• Formula: Quick Assets / Quick Liabilities

• How to Calculate Quick Assets:

  • Quick Assets = Current Assets - Inventories (Raw Material, Finished Goods, Work-in-Progress)

• How to Calculate Quick Liabilities:

  • Quick Liabilities = Current Liabilities - Bank Overdraft (if treated as a short-term loan)

• Industry Standard: A quick ratio of 1:1 (1 rupee of quick assets for every 1 rupee of quick liability) is generally considered a sound ratio.