# Financial Ratios

#### Working Capital Turnover Ratio

Working Capital Turnover Ratio is the Total revenue of a company divided by average working capital over the past 2 financial years. It measures how efficiently a company is using its working capital to support sales and growth. Also known as net sales to working capital, working capital turnover measures the relationship between the funds used to finance a company’s operations and the revenues a company generates to continue operations and turn a profit.

A higher working capital turnover ratio is better and indicates that a company is able to generate a larger amount of sales. However, if working capital turnover rises too high, it could suggest that a company needs to raise additional capital to support future growth.

#### Net Income / Liabilities

Net income divided by total liabilities for the most recent financial year. It is a measure to see if a company has enough cash flow to pay off long-term debts while also meeting other short-term obligations. Also, know as the solvency ratio, it can determine if a company’s finances are healthy enough to pay off long-term debts and still operate.

#### Days Payable Outstanding

Average number of days a company takes to make payments to its trade creditors.

A company with a higher value of DPO takes longer to pay its bills, which means that it can retain available funds for a longer duration, allowing the company an opportunity to utilize those funds in a better way to maximize the benefits. A high DPO, however, may also be a red flag indicating an inability to pay its bills on time.

#### Days of Sales Outstanding

Days of Sales Outstanding is the average number of days a company takes to collect payment of a sale.

A high DSO number suggests that a company is experiencing delays in receiving payments. That can cause a cash flow problem. A low DSO indicates that the company is getting its payments quickly. That money can be put back into the business to good effect.

It is important to note that DSO can vary from business to business. In the financial industry, relatively long payment terms are common. In the agriculture and fuel industries, fast payment can be crucial. In general, small businesses rely more heavily on steady cash flow than large, diversified companies.

#### Days of Inventory Outstanding

Days of Inventory Outstanding is the average number of days a company holds inventory before turning it into sales.

Indicating the liquidity of the inventory, the figure represents how many days a company’s current stock of inventory will last. Generally, a lower DIO is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.

DIO is a metric that analysts use to determine the efficiency of sales. A smaller number indicates that a company is more efficiently and frequently selling off its inventory, which means rapid turnover leading to the potential for higher profits (assuming that sales are being made in profit). However, this number should be looked upon cautiously as it often lacks context. DIO tends to vary greatly among industries depending on various factors like product type and business model. Therefore, it is important to compare the value among the same sector peer companies. Companies in the technology, automobile, and furniture sectors can afford to hold on to their inventories for long, but those in the business of perishable or fast-moving consumer goods (FMCG) cannot. Therefore, sector-specific comparisons should be made for DIO values.

#### Asset Turnover Ratio

Asset Turnover Ratio is calculated as the total revenue of a company divided by average total assets over the past 2 financial years.

The asset turnover ratio measures the value of a company’s sales or revenues relative to the value of its assets.

This metric helps investors understand how effectively companies are using their assets to generate sales. The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its assets to generate sales.

#### Inventory Turnover Ratio

The inventory turnover ratio is calculated as the Cost of goods sold of a company divided by average inventory over the past 2 financial years. Inventory turnover measures how many times in a given period a company is able to replace the inventories that it has sold.

A slow turnover implies weak sales and possibly excess inventory, while a faster ratio implies either strong sales or insufficient inventory. High volume, low margin industries such as retailers and supermarkets tend to have the highest inventory turnover.

#### Earning Power

Earning power is a company’s ability to generate profit. Specifically, its ability to generate profit from its operations. Investors and analysts calculate earning power to determine whether a company is worth investing in.

It is calculated by dividing EBIT with total assets for the most recent financial year. (EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.)

#### Long Term Debt to Equity

Long term (LT) Debt to Equity ratio is calculated as the ratio of LT debt of the company to the shareholders equity of the company for the most recent financial year. Long term debt refers to the loan amount raised by the company, which is repayable at least only after 1 year. Shareholders equity is the sum of profits retained by the company and amount invested into the company by shareholders

This ratio helps understand the extent to which the company is raising loans to fund projects. Suppose the LT debt of the company is Rs.130 and shareholders equity is Rs.100. Then LT debt equity ratio is 130/100 = 1.3

Interest expense is a fixed cost that has to be paid on loan / debt raised by the company. Higher the debt raised more the interest cost. So if the company funds projects using more of debt funds, interest expense automatically increases eating into profitability of the company. Hence, all other things remaining the same, company with lower long term debt to equity ratio is preferable compared to ones with higher ratio

A company with decreasing trend in LT debt to equity ratio over the medium term will usually see improved profits and record higher ROE. LT debt to equity ratio of companies operating in the same sector can also be compared with each other

#### Debt to Equity

Debt to Equity ratio is calculated as the total outstanding debt of the company divided by the shareholders equity of the company for the most recent financial year. To understand it better, please read about long term debt to equity ratio above. Total debt is the sum of all kinds of loan amount raised by the company regardless of repayment schedule

This ratio helps understand the extent to which debt capital is used to fund projects as well as to meet day to day working expenses of the company. Higher the debt capital, higher the interest cost leading to lower profits. Hence companies with lower debt to equity ratio are more preferable. Debt to equity ratio of companies operating in the same sector can be compared with each other

#### Quick Ratio

Quick ratio is calculated as total current assets minus inventory for the most recent financial period divided by total current liabilities for the same period. Current assets include short term assets like cash, inventory and receivables whereas current liabilities includes obligations that are due within 1 year such as short term debt, accounts payable etc. Since inventory cannot always be sold off at short notice, it is not considered a liquid asset

Suppose total current assets of a company is Rs.250, inventory is Rs.50 and current liabilities is Rs.300, quick ratio can be calculated as (250 – 50) / 300 = 0.67. So the company has Rs.0.67 quick asset to meet every Rs.1 current liability

Quick ratio allows to understand how quickly a company can meet its short term financial obligations, by monetising liquid assets. Higher the quick ratio better the liquidity situation of the company. Quick ratio of 2 or more companies operating in the same sector can be compared with each other

#### Current Ratio

Current Ratio is calculated as total current assets divided by total current liabilities for the most recent financial period. Current assets include short term assets like cash, inventory and receivables whereas current liabilities includes obligations that are due within 1 year such as short term debt, accounts payable etc

Suppose total current assets of a company is Rs.250 and current liabilities is Rs.300, current ratio can be calculated as 250 / 300 = 0.83. So the company has Rs.0.83 current assets to meet every Rs.1 current liability

The ratio helps understand the company’s ability to pay off its short term liabilities using its current assets. It is important to understand that while current ratio of 1 is considered optimal, an extreme divergence on either sides from this point is not desirable. A very low ratio indicates that the company is having trouble collecting from its debtors or takes a long time to sell inventory whereas a very high ratio indicates that the company might be holding lot of cash without investing the same appropriately

#### Cash Conversion Cycle

Cash conversion cycle is calculated as the sum of average inventory days and average receivables collection days minus average payables payment period for the financial year. The ratio, expressed in number of days, helps understand the length of time it takes to convert raw material into inventory, sell the inventory, collect cash from debtors and pay off creditors who supplied raw materials

For example if the company takes 28 days to manufacture the product and sell it on credit, 13 days to collect from debt holders and has 32 days time to pay of its creditors – cash conversion cycle is 28+13-32 i.e 9 days

Cash conversion cycle indicates how efficiently the company is using short-term assets and liabilities to generate cash. The lower the number of days, the more efficient the company is in converting raw material into finished products, selling the same and collecting cash

#### Interest Coverage Ratio

This ratio is calculated as earnings before interest and taxes (EBIT) for the most recent financial year divided by the interest expense for the same period. Earnings before interest and taxes is calculated as sales minus operating expense – which includes cost of goods sold, selling and general expenses etc. Interest expense is paid out on the outstanding debt amount of the company, higher the debt higher the interest pay out

Suppose EBIT of the company is Rs.120 and interest expense is Rs.50, interest coverage ratio is 2.4, indicating that the company has Rs.2.4 for every Re.1 of interest payment

This ratio helps understand whether the company can pay off its interest obligations in a timely manner. If the ratio is less than 1, it indicates that the company’s operating profit is not sufficient to make interest payments and that the financial health of the company is in dire straits. A number equal to 1 means all operating profits will be expended towards make interest payments and net profit will be zero. Higher the coverage ratio above 1 better the financial health of the company