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Definition
Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion of current
assets of a business in relation to its current liabilities.

2. Formula
Current Ratio

Current Assets
Current Liabilities

3. Explanation
Current ratio expresses the extent to which the current liabilities of a business (i.e. liabilities due to be
settled within 12 months) are covered by its current assets (i.e. assets expected to be realized within 12
months). A current ratio of 2 would mean that current assets are sufficient to cover for twice the amount of
a company's short term liabilities.

4. Example
ABC PLC has the following assets and liabilities as at 31st December 2012:

$m

$m

Non Current Assets

Goodwill
Fixed Assets

75
75 150

Current Assets
Cash in hand
Cash in bank
Inventory
Receivable
Current Liabilities

25
50
25
100 200

Trade payables
Income tax payables

100
60 160

Non Current Liabilities

Bank Loan
Deferred tax payable

50
25

75

Current ratio will be calculated as follows:

Current Ratio

Current Assets
Current Liabilities

200
160

1.25

Interpretation & Analysis

Current ratio is a measure of liquidity of a company at a certain date. It must be analyzed in the context of
the industry the company primarily relates to. The underlying trend of the ratio must also be monitored
over a period of time.
Generally, companies would aim to maintain a current ratio of at least 1 to ensure that the value of their
current assets cover at least the amount of their short term obligations. However, a current ratio of greater
than 1 provides additional cushion against unforeseeable contingencies that may arise in the short term.
Businesses must analyze their working capital requirements and the level of risk they are willing to accept
when determining the target current ratio for their organization. A current ratio that is higher than industry
standards may suggest inefficient use of the resources tied up in working capital of the organization that
may instead be put into more profitable uses elsewhere. Conversely, a current ratio that is lower than
industry norms may be a risky strategy that could entail liquidity problems for the company.
Current ratio must be analyzed over a period of time. Increase in current ratio over a period of time may
suggest improved liquidity of the company or a more conservative approach to working capital
management. A decreasing trend in the current ratio may suggest a deteriorating liquidity position of the
business or a leaner working capital cycle of the company through the adoption of more efficient
management practices. Time period analyses of the current ratio must also consider seasonal
fluctuations.
Liquidity Analysis Ratios
Current Ratio
Current Ratio =

Current Assets
-----------------------Current Liabilities

Quick Ratio
Quick Ratio =

Quick Assets
---------------------Current Liabilities

Quick Assets = Current Assets - Inventories

Net Working Capital Ratio
Net Working Capital Ratio =

Net Working Capital

-------------------------Total Assets

Net Working Capital = Current Assets - Current Liabilities

Profitability Analysis Ratios

Return on Assets (ROA)

Net Income
---------------------------------Average Total Assets

Return on Assets (ROA) =

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2

Return on Equity (ROE)
Net Income
-------------------------------------------Average Stockholders' Equity

Return on Equity (ROE) =

Average Stockholders' Equity

= (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2
Return on Common Equity (ROCE)
Return on Common Equity =

Net Income
-------------------------------------------Average Common Stockholders' Equity

Average Common Stockholders' Equity

= (Beginning Common Stockholders' Equity + Ending Common Stockholders' Equity) / 2
Profit Margin
Profit Margin =

Net Income
----------------Sales

Earnings Per Share (EPS)

Earnings Per Share =

Activity Analysis Ratios

Net Income
--------------------------------------------Number of Common Shares Outstanding

Assets Turnover Ratio

Assets Turnover Ratio =

Sales
---------------------------Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2

Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio =

Sales
----------------------------------Average Accounts Receivable

Average Accounts Receivable

= (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Inventory Turnover Ratio
Inventory Turnover Ratio =

Cost of Goods Sold

--------------------------Average Inventories

Average Inventories = (Beginning Inventories + Ending Inventories) / 2

Capital Structure Analysis Ratios

Debt to Equity Ratio
Debt to Equity Ratio =

Total Liabilities
---------------------------------Total Stockholders' Equity

Interest Coverage Ratio

Interest Coverage Ratio =

Income Before Interest and Income Tax Expenses

------------------------------------------------------Interest Expense

Income Before Interest and Income Tax Expenses

= Income Before Income Taxes + Interest Expense

Capital Market Analysis Ratios

Price Earnings (PE) Ratio
Price Earnings Ratio =

Market to Book Ratio

Market Price of Common Stock Per Share

-----------------------------------------------------Earnings Per Share

Market to Book Ratio =

Market Price of Common Stock Per Share

------------------------------------------------------Book Value of Equity Per Common Share

Book Value of Equity Per Common Share

= Book Value of Equity for Common Stock / Number of Common Shares
Dividend Yield
Dividend Yield =

Annual Dividends Per Common Share

-----------------------------------------------Market Price of Common Stock Per Share

Book Value of Equity Per Common Share

= Book Value of Equity for Common Stock / Number of Common Shares
Dividend Payout Ratio
Dividend Payout Ratio =

Cash Dividends
-------------------Net Income

ROA = Profit Margin X Assets Turnover Ratio

ROA = Profit Margin X Assets Turnover Ratio
Net Income
ROA =
------------------------ =
Average Total Assets

Net Income
-------------- X
Sales

Profit Margin = Net Income / Sales

Assets Turnover Ratio = Sales / Averages Total Assets

Working capital turnover ratio

Posted in: Financial statement analysis/Accounting ratios analysis
Working capital turnover ratio is computed by dividing the cost of goods sold by net working capital. It
represents how many times the working capital has been turned over during the period.

Formula:

Sales
------------------Average Total Ass

The formula consists of two components cost of goods sold and net working capital. If the cost of goods
sold figure is not available or cannot be computed from the available information, the total net sales can
be used as numerator.
Net working capital is equal to current assets minus current liabilities. This information is available from
thebalance sheet. For more explanation consider the following example:

Example:
Exide company sells batteries that are used in vehicles. The current assets and current liabilities as on 31
December, 2012 are given below:
Cost of goods sold

$ 300,000

Accounts payable

60,000

Inventory

40,000

Accounts receivables

50,000

Notes receivables

10,000

Cash

20,000

Required: Compute working capital turnover ratio from the above information.

Solution:

= 300,000 / 60,000
= 5 times
The working capital turnover ratio of Exide company is 5. It means the company has turned over its
working capital 5 times in 2012.

Interpretation:
Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient utilization of
working capital. The ratio should be carefully interpreted because a very high ratio may also be a sign of
insufficient working capital.

Fixed assets turnover ratio

Posted in: Financial statement analysis/Accounting ratios analysis
Fixed assets turnover ratio (also known as sales to fixed assets ratio) is a commonly used activity ratio
that measures the efficiency with which a company uses its fixed assets to generate its sales revenue. It
is computed by dividing net sales by average fixed assets.

Formula:

Note for students: Sometime opening balance of fixed assets may not be given in the question. In such
a case, closing balance of fixed assets rather than average assets may be used as denominator of the
formula.

Example:
X and Y are two independent companies that manufacture office furniture and distribute it to the sellers as
well as customers in various regions of USA . The selected data for both the companies is give below:
X

Annual sales

75,000

95,000

Sales returns

1,500

1,000

Net fixed assets at 1 January 2014

22,500

20,000

Net fixed assets at 31 December 2014

24,000

21,500

Required:
1.
2.

Calculate fixed assets turnover ratio for both the companies.

Can we compare the ratio of company X with that of company Y? If yes, which company is more
efficient in using its fixed assets?

Solution:
(1). Calculation of fixed assets turnover ratio:
X

Net sales (a)

73,500*

94,000*

Average fixed assets (b)

23,250**

20,750**

3.16

4.53

Fixed assets turnover ratio (a/b)

*Net sales:
X: 75,000 1,500
Y: 95,000 1,000
**Average fixed assets:
X: (22,500 + 24,000)/2
Y: (20,000 + 21,500)/2
(2). Comparison of two companies:
The ratio of company X can be compared with that of company Y because both the companies belong to
same industry. Generally speaking the comparability of ratios is more useful when the companies in
question are in the same industry.
Company Y generates a sales revenue of $4.53 for each dollar invested in fixed assets where as
company X generates a sales revenue of $3.16 for each dollar invested in fixed assets. Company Y is
therefore more efficient than company X in using the fixed assets.

Significance and interpretation:

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a low ratio
means inefficient or under-utilization of fixed assets. The usefulness of this ratio can be increased by
comparing it with the ratio of other companies, industry standards and past years.

Net profit (NP) ratio

Posted in: Financial statement analysis/Accounting ratios analysis
Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship between net profit after
tax and net sales. It is computed by dividing the net profit (after tax) by net sales.

Formula:

For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax.
All non-operating revenues and expenses are not taken into account because the purpose of this ratio is
to evaluate the profitability of the business from its primary operations. Examples of non-operating
revenues include interest on investments and income from sale of fixed assets. Examples of nonoperating expenses include interest on loan and loss on sale of assets.
The relationship between net profit and net sales may also be expressed in percentage form. When it is
shown in percentage form, it is known as net profit margin. The formula of net profit margin is written as
follows:

Example:
Sales

$ 210,000

Returns inwards

10,000

Gross profit

80,000

Administrative expenses

15,000

Selling expenses

15,000

Interest on investment

10,000

Loss on account of fire

6,000

Income tax

5,000

Net profit ratio would be computed as follows:

= ($45,000* / 200,000**)
= 0.225 or 22.5%
*Computation of net operating profit after tax:
Gross profit
Less operating expenses:

80,000

Administrative expenses

15,000

Selling expenses

15,000 30,000
-

Net operating profit before tax

50,000

Less income tax

5,000
-

Net operating profit after tax

45,000
-

Note: Interest on investment and loss on account of fire has been ignored because interest on investment
is a non-operating income and loss on account of fire is a non-operating loss.
** Computation of net sales:
210,000 10,000 = 200,000

Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio
indicates the efficient management of the affairs of business.
There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability
or not, the analyst should compare the ratio with the previous years ratio, the industrys average and the
budgeted net profit ratio.
The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably
the assets have been used during the period.

Gross profit ratio (GP ratio)

Posted in: Financial statement analysis/Accounting ratios analysis
Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between gross profit and
total net sales revenue. It is a popular tool to evaluate the operational performance of the business . The
ratio is computed by dividing the gross profit figure by net sales.

Formula:
The following formula/equation is used to compute gross profit ratio:

When gross profit ratio is expressed in percentage form, it is known as gross profit margin or gross profit
percentage. The formula of gross profit margin or percentage is given below:

The basic components of the formula of gross profit ratio (GP ratio) are gross profit and net sales.
Gross profit is equal to net sales minus cost of goods sold. Net sales are equal to total gross sales less
returns inwards and discount allowed. The information about gross profit and net sales is normally
available fromincome statement of the company.

Example:
The following data relates to a small trading company. Compute the gross profit ratio (GP ratio) of the
company.
Gross sales

1,000,000

Sales returns

90,000

Opening stock

200,000

Purchases

590,000

Purchases returns

70,000

Closing stock

45,000

Solution:
With the help of above information, we can compute the gross profit ratio as follows:

= (235,000 / 910,000)
= 0.2582 or 25.82%
The GP ratio is 25.82%. It means the company may reduce the selling price of its products by 25.82%
without incurring any loss.

*Computation of gross profit:

Sales

1,000,000

Less sales returns

90,000
-

Net sales

910,000

Less cost of goods sold:

Opening inventory

200,000

Purchases

590,000

Purchases returns

70,000

520,000

Available for sale

720,000

Less closing inventory

45,000

675,000

Gross profit

235,000
-

Significance and interpretation:

Gross profit is very important for any business. It should be sufficient to cover all expenses and provide
for profit.
There is no norm or standard to interpret gross profit ratio (GP ratio). Generally, a higher ratio is
considered better.
The ratio can be used to test the business condition by comparing it with past years ratio and with the
ratio of other companies in the industry. A consistent improvement in gross profit ratio over the past years
is the indication of continuous improvement . When the ratio is compared with that of others in the
industry, the analyst must see whether they use the same accounting systems and practices.

Price earnings ratio (P/E ratio)

Posted in: Financial statement analysis/Accounting ratios analysis
Price earnings ratios (P/E ratio) measures how many times the earnings per share (EPS) has been
covered by current market price of an ordinary share. It is computed by dividing the current market price
of an ordinary share by earnings per share.

Formula:
The formula of price earnings ratio is given below:

Example:
The market price of an ordinary share of a company is $50. The earnings per share is $5. Compute price
earnings ratio.

Solution:

=$50 / $5
= 10
The price earnings ratio of the company is 10. It means the earnings per share of the company is covered
10 times by the market price of its share. In other words, $1 of earnings has a market value of $10.

Use of P/E ratio:

P/E ratio is a very useful tool for financial forecasting. It gives information about the amount that the
investors are willing to invest in the company to earn $1.
It also helps in knowing whether the market price of share is reasonable or not. For example, the market
price of a share of XY Limited is $60 and the earnings per share is $10. The price earnings ratio of similar
companies in the same industry is 8. It means the market value of a share of XY Limited should be $80
(i.e., 8 $10). The market value of XY Limited is, therefore, under valued by $20. If the P/E ratio of similar
companies is $4, the market value of a share of XY Limited should have been $40 ($4 $10), thus the
share is over valued by $20.
A higher P/E ratio is the indication of strong position of the company in the market and a fall in ratio
should be investigated.

Operating ratio
Posted in: Financial statement analysis/Accounting ratios analysis

Operating ratio is computed by dividing operating expenses by net sales. It is expressed in percentage.

Formula:
Operating ratio is computed as follows:

The basic components of the formula are operating cost and net sales. Operating cost is equal to cost of
goods sold plus operating expenses. Non-operating expenses such as interest charges, taxes etc., are
excluded from the computations.
The following example may be helpful in understanding the computation of operating ratio:

Example:
The selected data from the records of Good Luck limited is given below:
$
Net sales

200,000

Cost of goods sold

120,000

Administrative expenses

20,000

Selling expense

20,000

Interest charges

10,000

Required: Compute operating ratio for Good Luck limited from the above data.

Solution:

= (160,000* / 200,000) 100

= 80%
The operating profit ratio is 80%. It means 80% of the sales revenue would be used to cover cost of
goods sold and operating expenses of Good Luck limited.

*Computation of operating cost:

Cost of goods sold + Administrative expenses + Selling expenses
= $120,000 + $20,000 + $20,000
= $160,000
Notice that the interest charges have not been included in operating cost because they are not operating
expenses.

Significance and interpretation:

This ratio is used to measure the operational efficiency of the management. It shows whether the cost
component in the sales figure is within normal range. A low operating ratio means high net profit ratio i.e.,
more operating profit.
The ratio should be compared: (1) with the companys past years ratio, (2) with the ratio of other
companies in the same industry. An increase in the ratio should be investigated and brought to attention
of management. The operating ratio varies from industry to industry.

Return on shareholders investment/Return on equity

Posted in: Financial statement analysis/Accounting ratios analysis
Return on shareholders investment ratio is a measure of overall profitability of the business and is
computed by dividing the net income after interest and tax by average stockholders equity. It is also
known as return on equity (ROE) ratio and return on net worth ratio. The ratio is usually expressed in
percentage.

Formula:

The numerator consists of net income after interest and tax because it is the amount of income available
for common and preference stockholders. The denominator is the average of stockholders equity
(preference and common stock). The information about net income after interest and tax is normally
available from income statement and the information about preference and common stock is available
frombalance sheet.

Note for students: Analysts usually prefer to use the average stockholders equity as denominator. The
students can, however, use the closing figure of stockholders equity if the opening figure is not given in
the question.

Example:
The following data has been extracted from the income statement and balance sheet of PQR limited:
Data extracted from Income statement:
Net operating income

Interest expenses

510,000
65,000

Net income before tax

445,000

Income tax (30%)

115,500

Net income

329,500

2011

Data extracted from balance sheet:

Preferred stock $100 par, 9%
Common stock, $12 par
Additional paid in capital

Total paid-in capital

Retained earnings

Total stockholders equity

800,000

2012
$

800,000

1,200,000

1,200,000

50,000

50,000

2,050,000

2,050,000

500,000

350,000

2,550,000

2,400,000

Required: Compute return on shareholders investment/Return on equity ratio

Solution:

= (329,500 / 2,475,000*) 100

= 13.31%
*Average stockholders equity:
=(2,400,000 + 2,550,000) / 2
= 2,475,000
The return on shareholders investment or return on equity (ROE) ratio of PQR limited is 13.31%. It
means for every $100 invested by shareholders, the company earns $13.31 after interest and tax.

Significance and Interpretation:

Return on equity (ROE) is widely used to measure the overall profitability of the company from preference
and common stockholders view point. The ratio also indicates the efficiency of the management in using
the resources of the business.
Higher ratio means higher return on shareholders investment. Investors always search for the highest
return on their investment and a company that has higher ROE ratio than others in the industry attracts
more investors.