Lesson 16 of 33 · Free
Contents
- 1 Financial Ratios
- 1.1 Why ratios?
- 1.2 1. Liquidity — can we pay the next bill?
- 1.3 2. Solvency — can we survive long-term?
- 1.4 3. Profitability — how well are we earning?
- 1.5 4. Efficiency — how fast do assets turn?
- 1.6 Bonus: the DuPont decomposition
- 1.7 Three rules for ratio analysis
- 1.8 Lesson recap
- 1.9 Practical Indian Application
- 1.10 Indian Application & Regulatory Context
- 1.11 Worked Example — Pidilite Industries Ratio Snapshot
- 1.12 Common Mistakes
- 1.13 Frequently Asked Questions
- 1.14 DuPont Decomposition
Financial Ratios
Four families of ratios — liquidity, solvency, profitability, efficiency. Plus the DuPont decomposition and the rules for not getting fooled by a single number.
Why ratios?
A balance sheet that says “₹250 crore total assets” is meaningless on its own. Compared to industry peers, to last year, or to debt levels, the same number tells you whether the business is healthy, growing, leveraged, or in trouble. Financial ratios are how analysts compare apples to apples — by dividing one number by another to neutralise size differences.
1. Liquidity — can we pay the next bill?
- Current ratio = Current assets ÷ Current liabilities. Healthy: 1.5-2.0. Below 1 means current assets won’t cover current obligations.
- Quick ratio (acid test) = (Current assets − Inventory) ÷ Current liabilities. Stricter — inventory may not convert to cash quickly.
- Cash ratio = (Cash + marketable securities) ÷ Current liabilities. The most conservative version.
2. Solvency — can we survive long-term?
- Debt-to-equity = Total liabilities ÷ Total equity. Above 2 typically means high leverage; varies wildly by industry (utilities and banks run higher).
- Debt-to-assets = Total liabilities ÷ Total assets. Shows what fraction of assets are funded by debt.
- Interest coverage = EBIT ÷ Interest expense. Below 1.5 is alarming; above 3 is comfortable.
- DSCR (Debt Service Coverage) = Operating cash flow ÷ (Interest + Principal). Lenders’ favourite.
3. Profitability — how well are we earning?
- Gross margin = Gross profit ÷ Revenue. SaaS: 70%+. Software product: 80%+. Retail: 25-35%. Heavy manufacturing: 15-25%.
- Operating margin = Operating income ÷ Revenue. How well the business is run, separated from financing and tax.
- Net margin = Net income ÷ Revenue. Bottom-line yield.
- ROA = Net income ÷ Average total assets. How effectively assets generate profit.
- ROE = Net income ÷ Average equity. Owners’ return on capital.
- ROIC = NOPAT ÷ Invested capital. Best single measure of value creation.
4. Efficiency — how fast do assets turn?
- Inventory days = Inventory ÷ COGS × 365. Lower is better; signals fast turnover.
- Receivable days (DSO) = AR ÷ Revenue × 365. How long customers take to pay.
- Payable days (DPO) = AP ÷ COGS × 365. How long you take to pay suppliers.
- Cash conversion cycle = Inventory days + Receivable days − Payable days. Days of working capital needed.
- Asset turnover = Revenue ÷ Average total assets. Revenue intensity per ₹ of assets.
Bonus: the DuPont decomposition
A famous identity that splits ROE into three drivers:
A high ROE comes from one or more of: fat margins (luxury, software), fast asset turnover (retail, distribution), or high leverage (banks). Decomposing tells you which driver is producing the ROE — and whether it’s sustainable.
Three rules for ratio analysis
- Compare against something. A 12% ROE means nothing until you compare to industry average or last year.
- Always look at trends. A single year is a snapshot; trends reveal trajectory.
- Cross-check with cash flow. A company can manipulate accrual-based ratios; manipulating cash flow is much harder. Always sanity-check ROE against operating cash flow per equity.
Lesson recap
- Four families: liquidity, solvency, profitability, efficiency.
- Each ratio answers a specific question; cherry-pick a handful from each family.
- DuPont decomposes ROE into margin × turnover × leverage.
- Always compare ratios against peers and trends; never read in isolation.
Cement what you just learned
Head to our free Study Hub and find Financial Ratios. Each topic comes with four interactive study modes — quiz yourself, flip through flashcards, unscramble jumbled terms, and solve a topic-specific crossword. No login required.
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Apply what you’ve learned
Practical Indian Application
Reference tools: Screener.in for instant ratio computation across 1,500+ Indian listed companies; Tijori Finance for subsidiary-wise rolled-up ratios; ICAI’s Guidance Note on Financial Ratios for exact formulas.
Indian Application & Regulatory Context
Indian rating agencies (CRISIL, ICRA, CARE, India Ratings) use composite ratio frameworks to assign credit ratings from AAA to D. A change in DSCR (Debt Service Coverage Ratio) from 1.5 to 1.2 can trigger a rating downgrade, raising borrowing cost by 50-100 bps. SEBI LODR requires listed companies to disclose specific ratios in their annual report under Schedule V. RBI’s Internal Ratings Based approach uses similar frameworks for bank lending decisions. Practitioners build ratio dashboards in Excel or Power BI fed from Tally/SAP exports for continuous monitoring.
Worked Example — Pidilite Industries Ratio Snapshot
Suppose Pidilite Industries FY25 (illustrative): Current Assets ₹4,800 cr, Current Liabilities ₹2,000 cr, Total Debt ₹500 cr, Equity ₹7,200 cr, EBIT ₹2,100 cr, Interest ₹40 cr, PAT ₹1,500 cr, Revenue ₹13,000 cr, Average Total Assets ₹10,000 cr.
- Current Ratio: 4,800/2,000 = 2.4
- Debt-Equity: 500/7,200 = 0.07
- Interest Coverage: 2,100/40 = 52×
- ROE: 1,500/7,200 = 20.8%
- ROCE: 2,100/(7,200+500) = 27.3%
- Asset Turnover: 13,000/10,000 = 1.3×
- PAT Margin: 1,500/13,000 = 11.5%
The ratios paint a picture of high return, low leverage, and strong liquidity — the financial signature of a premium FMCG/specialty brand. An analyst would benchmark these against Asian Paints, Berger and competitors to judge relative quality.
Common Mistakes
- Computing ratios without benchmarking — a Current Ratio of 1.5 is healthy for FMCG but worrying for utilities
- Ignoring trend — one-year ratios are noise; 5-year trends reveal direction
- Mixing standalone and consolidated ratios — pick one approach consistently
- Forgetting that Ind AS 116 (Leases) inflates Debt and Total Assets, affecting Debt-Equity and ROCE
Frequently Asked Questions
Which is the single most important ratio?
No one ratio rules all. Investors focus on ROCE or ROE for quality, Debt-Equity for risk. Bankers emphasise Interest Coverage and DSCR. Choose based on your decision context.
How does Ind AS impact ratio comparison?
Adoption of Ind AS 116 brings operating leases on balance sheet, raising Debt and Total Assets and lowering ROCE and Asset Turnover compared to AS-following peers.
DuPont Decomposition
The DuPont identity decomposes Return on Equity into three drivers: ROE = (Net Margin) × (Asset Turnover) × (Equity Multiplier). This breakdown explains WHY a company has high or low ROE — is it operational efficiency, asset utilisation, or leverage? Indian FMCG firms (HUL, Asian Paints) have low asset multipliers but high margins; banks (HDFC, ICICI) have high asset multipliers and moderate margins; manufacturers (Tata Steel, Hindalco) sit in between. Indian benchmarks (illustrative): FMCG ROE 35-50%, ROCE 35-55%, PAT margin 15-20%. IT services ROE 20-30%. Banks ROE 12-18%. Cement ROE 12-18%. These benchmarks anchor any ratio analysis with peer-context.
Closing Note on Ratios
Build a personal Excel template with the 12 core ratios and apply it to 5-10 companies in your watchlist over 5 years of historical data. The patterns reveal far more than any individual snapshot. Combine ratios with industry benchmarks from CRISIL, ICRA, and broker reports for context. Within 90 days you will develop intuition for what “good” looks like in each sector — the foundation skill for equity research.
Industry Benchmarks Worth Memorising
Approximate 5-year average benchmarks across Indian sectors (illustrative, varies by cycle):
- FMCG (HUL, Nestle, ITC, Britannia): ROE 30-50%, ROCE 30-55%, PAT margin 12-20%, Asset turnover 1.5-2.5x
- IT Services (TCS, Infosys, Wipro, HCL): ROE 20-30%, ROCE 25-35%, PAT margin 15-22%, very low debt
- Banks (HDFC, ICICI, SBI): ROA 1-2%, ROE 12-18%, Net Interest Margin 3-4%, GNPA 1-3%
- Cement (UltraTech, Shree, ACC): ROE 12-18%, ROCE 12-18%, EBITDA margin 18-25%
- Pharma (Sun, Cipla, Lupin, DRL): ROE 15-25%, R&D spend 6-10% of revenue
- Auto (Maruti, M&M, Tata): ROE 10-18%, working capital cycle 30-45 days
- Real Estate (DLF, Godrej, Macrotech): Highly cyclical; DSCR more important than ROE in down cycles
Always compare a company’s ratios to its INDUSTRY peers, never to a random index average. A 15% ROE is mediocre for FMCG but excellent for steel.