FORMULAE OF RATIOS AND THEIR INTERPRETATIONS

Name of ratio Formula Interpretation

Gross margin (profit It reflects the gross margin earned by the firm
ratio) Gross margin ÷ Net sales revenue through manufacturing or trading as a proportion of
revenue. The gross profit margin reflects the
company’s performance based on the cost of
production and the efficiency of reducing the
manufacturing cost. It is believed that this ratio
should be constant or show an upward trend, which
in turn reflects the operational and cost efficiency of
the organization. This ratio in most cases is useful
for manufacturing organizations.
Profit margin Net income or PAT ÷ Sales revenue The net profit ratio is computed to measure the
overall efficiency of the organization based on its
revenue. This ratio can be calculated with profit
before tax or profit after tax, and it reflects the
overall organizational efficiency.
Return on assets Profit after tax ÷ Total assets
Or
It indicates the profit earned on assets used.
[Net income + Interest (1— Tax rate)]
÷ (Total assets)
Return on invested [Net income + Interest (1— Tax rate)])
capital ÷ (Long term liabilities
The objective of ROIC is to use permanent capital. It
(ROIC) + Shareholders′ equity)
assesses how efficiently a company is able to get the
Or
cash flow relative to the capital it has invested in its
Earnings before interest, tax,
EBITDA ( ) business.
depreciation, and amortization
÷ [Debt (Outside liabilities) + Equity]
 Return on This ratio reflects the earnings on the shareholders’
shareholders’ Net income or PAT ÷ Shareholders′ equity fund, i.e., equity, reserves, and surpluses. It
equity (ROE) indicates the return of the owners’ fund and shows
the management and owners of the company the
trend of profits generated by the company.
Earnings per share Net income or PAT ÷ Number of shares outstanding This is the amount of profit available to each equity
(EPS) shareholder after payment of all other expenses.
This ratio is useful to potential investors for making
investment decisions and is also used to give
shareholders information about the earnings on their
shares.
Price–earnings Market price per share ÷ Net income per share (EPS) The P/E ratio is a prominent indicator of a firm’s
ratio performance vis-à-vis the market price of its common
(P/E ratio) stock. The P/E ratio indicates the performance of the
company as anticipated/judged by investors. It also
indicates how the company will
perform in the future in the view of the market and
investors.
Assets turnover Sales revenue ÷ Total assets It indicates efficiency in asset use and explains the
ratio revenue-generating capacity with the help of total
assets.
Fixed assets Sales revenue ÷ Fixed assets This explains the revenue-generating capacity of
turnover the firm with respect to the fixed assets employed.
Capital intensity Sales revenue ÷ PPE (property, plant & equipment) Companies with large investments in PPE (such as
petrochemical firms, refineries, and steel firms) focus
on this ratio. Investments in PPE severely impact the
cyclical fluctuations in the business
activity of a firm. This ratio indicates the contribution
by PPE to the revenue of the company.
 Invested capital Sales revenue ÷ (Long term liabilities + This ratio is analyzed in comparison with return on
turnover shareholders’ equity) investment (ROI). ROI is the firm’s profit margin ×
investment turnover.
Inventory turnover Cost of goods sold or Cost of sales This ratio explains the movement of inventories in
Average inventory relation to revenue. A high inventory turnover ratio
indicates fast movement of inventory. A low
inventory turnover ratio indicates slow movement of
inventory, which further indicates the firm’s efficient
movement of inventory.
Inventory days 365 days or 52 weeks or 12 months
Inventory turnover
This ratio indicates the movement of the firm’s
Or
inventory in days.
Inventory
Cost of sales ÷ 365
Receivable Credit sales ÷ Average accounts receivable This indicates the movement of debtors with
turnover reference to credit revenue. It is computed to
assess the efficiency in the management/collection
of accounts receivable.
Receivable days 365 days or 52 weeks or 12 months
Receivable turnover
This indicates the management of receivables in
Or
days.
Average accounts receivable
Credit sales ÷ 365
Payable turnover Credit purchases This indicates payables with reference to credit
Average accounts payable purchases. It is computed whether payables are
paid on time or not.
 Payable days 365 days or 52 weeks or 12 months
Payable turnover This indicates how many days’ payment is made to
Or suppliers. It assesses the efficiency in the
Average accounts payable management/payment of accounts payable.
Credit sales ÷ 365
Working capital Sales revenue ÷ Working capital
turnover
This ratio explains how quickly the working capital,
(where Working
i.e., the net current assets, rotates. The higher the
capital is Current
turnover, the better the working capital utilization.
assets — Current
liabilities)
Current ratio Current assets ÷ Current liabilities This ratio indicates the company’s ability to pay its
short-term liabilities (payables). The higher the ratio,
the more capable the company is of paying its
current obligations. However, a high current ratio
also indicates a large portion of working capital,
which may reduce the firm’s profitability. Hence, the
ratio should be neither too high nor too low.
Acid test (quick) Quick assets ÷
This ratio is calculated to assess the liquidity position
ratio Current liabilities
of the firm. How fast can the firm pay its present
(Monetary current assets
obligations? This ratio is a more rigorous test of
= Quick assets – Inventory – Prepaid
liquidity than the current ratio.
expenses)
Financial leverage This ratio measures the total debt load of a company
ratio Assets ÷ Shareholders’ equity and then compares it with either assets or equity. It
indicates the ratio of assets owned by shareholders
and creditors. When the majority of the assets are
owned by shareholders of the company, it is believed
that the firm is less leveraged. When creditors own
the majority of the assets, it is said to be highly
leveraged. This indicator is required to assess the
riskiness in the capital structure of any organization
in order to decide whether the investment in such a
firm should
be undertaken or not.
Debt-to-equity ratio Long term liabilities ÷ Shareholders’ equity Debt usually has a lower cost than cost of equity;
Or hence, it is used to improve ROE. Raising financing
Total liabilities ÷ Shareholders’ equity through debt increases the fixed liabilities in terms of
the payment of interest. It also adds to financial risk.
Such liability has to be met even if the business is
not performing well. The entity may suffer a loss if
the ROI is lower than the cost of debt (interest);
therefore, the debt-to-equity ratio should
be reasonable.
Debt capitalization Long term liabilities This ratio indicates the financial risk taken by the
Long term liabilities + Shareholders’ equity company. It indicates to investors the risk of
investing in the business.
 Times interest Pretax operating profit + Interest The lower the interest coverage ratio, the higher the
earned or the Interest company’s debt burden and the higher the possibility
interest coverage Or of default. This ratio determines how easily the
ratio Earnings before interest and taxes company can make payments of interest on
Interest outstanding loans. A high interest coverage ratio
indicates the strength of the company to pay
interest.
Proprietary fund Proprietary funds ÷ Total assets A proprietary fund means equity (i.e., share capital,
ratio Or free reserves of the firm, net of losses, and fictitious
Net worth ÷ Total assets assets like preliminary expenses). Total assets
Or exclude fictitious assets. This ratio explains the
Proprietary funds ÷ Total funds proportion of total assets financed out of proprietary
funds. The higher the ratio, the lower the
dependence on outside funds and the more stable
the position of the company is in the long run.
Dividend yield Dividend per share ÷ Market price per share This ratio indicates the dividend paid by the
company each year relative to its share price.
Dividend payout Dividends ÷ Net income This ratio indicates the amount of profit distributed to
Or the shareholders and the amount kept as retained
Dividends ÷ Earnings per share earnings in the business. When compared with the
industry and previous years, it shows good future
prospects of the company if the retained
earnings are high and the payout is low.

Source: The formulae for ratios are derived from the following source (the interpretations are the authors’): Robert N. Anthony, David F. Hawkins, and Kenneth A.
Merchant, Accounting: Text and Cases, 13th ed. (New York: McGraw-Hill/Irwin, 2013), 380–381.