Chapter 16 · Financial Ratios
Return, liquidity and leverage ratios
Does it use money well, can it pay its bills, and does it owe too much?
Return ratios — how well is capital used?
| Ratio | Formula | Use it for |
|---|---|---|
| ROE | Net profit ÷ Shareholders' equity | The headline for banks |
| ROA | Net profit ÷ Total assets | Comparing asset-heavy businesses |
| ROCE | EBIT ÷ (Total assets − Current liabilities) | Return before financing choices |
| ROIC | After-tax EBIT ÷ Invested capital | The purest measure of operating skill |
Liquidity ratios — can it pay what is due soon?
| Ratio | Formula |
|---|---|
| Current ratio | Current assets ÷ Current liabilities |
| Quick ratio | (Current assets − Inventory) ÷ Current liabilities |
The quick ratio strips out inventory because inventory is the current asset least certain to become cash on demand. A wide gap between the two ratios means the company's short-term safety depends on selling stock.
Leverage ratios — how much does it owe?
| Ratio | Formula | Reading |
|---|---|---|
| Debt to equity | Total debt ÷ Equity | Above 2 is heavy for most non-financials |
| Interest coverage | EBIT ÷ Interest expense | Below 2 is uncomfortable; below 1 means profit does not cover interest |
| Asset turnover | Revenue ÷ Total assets | How much sales each rupee of assets produces |
| Inventory turnover | COGS ÷ Average inventory | How fast stock moves |
Worked example, continued
Using the earlier figures — equity Rs 2,80,00,000; net profit Rs 56,25,000; EBIT Rs 1,00,00,000; interest Rs 25,00,000; debt Rs 3,00,00,000; assets Rs 8,40,00,000.
- ROE = 56,25,000 ÷ 2,80,00,000 = 20.1%
- ROA = 56,25,000 ÷ 8,40,00,000 = 6.7%
- Debt to equity = 3,00,00,000 ÷ 2,80,00,000 = 1.07
- Interest coverage = 1,00,00,000 ÷ 25,00,000 = 4.0
ROE of 20% looks strong until you notice debt roughly equals equity — a meaningful part of that return is borrowed. Interest coverage of 4 is comfortable but not generous: a third off operating profit would take it to 2.7, and half would take it near the danger line.
Saved in this browser only — there is no account to create. Clearing your browser data clears your progress.