The Twelve Financial Ratios Worth Computing
- The company
- Liquidity: can it pay what falls due?
- Efficiency: how hard is the capital working?
- Gearing: who funded this, and can it service the debt?
- Profitability: is the trading any good?
- Return: was the capital worth committing?
- Reading them together
- Three cautions
- Where this fits
Textbooks list fifty ratios. Most analysts use about a dozen, and the rest are variations that rarely change a decision. These twelve cover liquidity, efficiency, gearing, profitability and return, which is every question you would normally ask of a set of accounts.
All of them are computed below from one company’s figures so you can see them relate to each other rather than float free.
The company
A mid-sized trading business, figures in ₹ lakh.
| Profit and loss | ₹ lakh | Balance sheet | ₹ lakh |
|---|---|---|---|
| Revenue | 1,200 | Inventory | 185 |
| Cost of goods sold | 900 | Trade receivables | 210 |
| Gross profit | 300 | Cash and bank | 35 |
| Operating expenses | 195 | Current assets | 430 |
| EBIT | 105 | Net fixed assets | 340 |
| Interest | 28 | Total assets | 770 |
| Profit before tax | 77 | Trade payables | 155 |
| Tax | 20 | Short-term borrowings | 120 |
| Profit after tax | 57 | Current liabilities | 275 |
| Long-term debt | 145 | ||
| Equity | 350 |
Liquidity: can it pay what falls due?
1. Current ratio = current assets ÷ current liabilities = 430 ÷ 275 = 1.56
Answers: is there enough short-term asset to cover short-term obligation? Below 1.0 is a warning. Comfortably above 2.0 in a trading business often means idle stock rather than strength.
2. Quick ratio = (current assets − inventory) ÷ current liabilities = 245 ÷ 275 = 0.89
Answers: the same question without assuming stock can be sold quickly. The gap between 1.56 and 0.89 is the whole story of this business: its liquidity is inventory.
Efficiency: how hard is the capital working?
3. Inventory days = (inventory ÷ COGS) × 365 = (185 ÷ 900) × 365 = 75 days
4. Receivable days = (receivables ÷ revenue) × 365 = (210 ÷ 1,200) × 365 = 64 days
5. Payable days = (payables ÷ COGS) × 365 = (155 ÷ 900) × 365 = 63 days
Together these give a cash conversion cycle of 75 + 64 − 63 = 76 days. That is the number that actually drives the funding requirement, and it is why working capital needs computing rather than guessing.
6. Asset turnover = revenue ÷ total assets = 1,200 ÷ 770 = 1.56 times
Answers: how much revenue does each rupee of assets generate? Trading and distribution businesses run high; manufacturing and infrastructure run low. Comparing across sectors is meaningless.
Gearing: who funded this, and can it service the debt?
7. Debt-to-equity = total debt ÷ equity = (145 + 120) ÷ 350 = 0.76
Counts borrowings only.
8. TOL/TNW = total outside liabilities ÷ tangible net worth = 420 ÷ 350 = 1.20
Counts everything owed, including trade payables, against equity stripped of intangibles. This company has no intangibles, so tangible net worth equals equity. Where a company does carry goodwill, the two ratios diverge sharply, and TOL/TNW is the one a bank will use.
9. Interest cover = EBIT ÷ interest = 105 ÷ 28 = 3.75 times
Answers: how far can profit fall before interest cannot be paid? This is usually the more binding covenant, because it responds to a bad trading year immediately while a balance sheet ratio lags.
Profitability: is the trading any good?
10. Gross margin = gross profit ÷ revenue = 300 ÷ 1,200 = 25.0%
Answers: what survives the direct cost of what you sell? Moves with pricing, input costs and mix, and is the first place to look when profit falls without revenue falling.
11. Operating margin = EBIT ÷ revenue = 105 ÷ 1,200 = 8.75%
Answers: what survives after running the business, before financing and tax. The gap between gross and operating margin is your overhead burden: here 16.25 points of revenue.
Return: was the capital worth committing?
12. Return on capital employed = EBIT ÷ (equity + long-term debt) = 105 ÷ 495 = 21.2%
Answers the only question an owner really has: does this business earn more than the capital costs? Compare it against your borrowing rate. Earning 21.2% on capital while borrowing at 11% is value creation; the reverse is not, however large the revenue.
Reading them together
Individually each number is a fact. Together they form an argument.
This business earns a healthy 21.2% on capital employed and a reasonable 8.75% operating margin, but its quick ratio is below 1.0 and its cash conversion cycle is 76 days. It is profitable and tight. The constraint is not earnings, it is that ₹185 lakh sits in stock and ₹210 lakh in receivables while ₹120 lakh of short-term borrowing funds part of it.
The single highest-value action follows directly: reduce inventory days. Cutting 75 days to 60 releases roughly ₹37 lakh, which repays a third of the short-term borrowing, lifts interest cover and moves the quick ratio above 1.0. No other lever on this page does as much.
That is what ratio analysis is for. Not to produce twelve numbers, but to find the one thing worth doing.
Three cautions
A ratio is a comparison or it is nothing. 1.56 means little until set against last year, against a competitor, or against a covenant.
Year-end figures flatter. Receivables are chased and stock run down before a balance sheet date. Averages of opening and closing balances are more honest.
Benchmarks are sector-specific. An asset turnover of 1.56 is unremarkable for a distributor and would be extraordinary for a power producer. Published “ideal” figures without a sector attached should be treated as decoration.
Where this fits
- Where the inputs come from: how to read a balance sheet
- The third statement: how to read a cash flow statement
- Turning the cycle into rupees: how much working capital you need
- The ratio your banker uses: TOL/TNW
- Your own figures: working capital calculator
- Terms used here: accounting glossary