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Ratio analysis is a fundamental technique used by banking professionals and credit analysts to evaluate financial statements by examining mathematical relationships between accounting figures. Understanding ratio analysis banking is essential for assessing borrower creditworthiness and making informed lending decisions.
What is Ratio Analysis?
Ratio analysis is a technique used to evaluate financial statements by examining the mathematical relationships between accounting figures. These ratios provide meaningful insights into a company’s operational efficiency, profitability, solvency, and liquidity.
For banking professionals and credit analysts, ratio analysis is essential for assessing borrower creditworthiness, understanding financial health, and making informed lending decisions. Banks rely heavily on ratio analysis to evaluate loan applications, monitor ongoing credit facilities, and assess default risk.
Classification of Ratios
By Source (Statement-based)
- P&L Ratios: Derived from Profit & Loss statements (profitability ratios)
- Balance Sheet Ratios: Derived from Balance Sheet (liquidity, solvency ratios)
- Composite/Inter-Statement Ratios: Combine data from P&L and Balance Sheet (turnover ratios, EPS)
By Function (What They Measure)
- Profitability Ratios: Gross profit, net profit, return on capital employed
- Turnover/Activity Ratios: Asset utilization, inventory turnover, debtor collection
- Solvency Ratios:
- Long-term ratios: debt-equity, fixed asset ratio
- Short-term/Liquidity Ratios: current ratio, quick ratio
Key Profitability Ratios
Return on Capital Employed (ROCE)
Formula:
EBIT × 100 / Capital Employed
Where:
- EBIT: Earnings before Interest & Tax (operating profit)
- Capital Employed: Share Capital + Reserves & Surplus + Long-term Loans − (Non-business assets + Fictitious assets)
ROCE shows how efficiently the company generates returns from its capital base. A higher ROCE indicates better capital utilization. For banking professionals, ROCE is a critical metric in ratio analysis banking as it reflects management’s effectiveness in deploying capital.
Earnings Per Share (EPS)
Formula:
Net Profit after Tax and Preference Dividend / Number of Equity Shares
EPS indicates the profit available to each equity shareholder. It helps investors estimate the market value and dividend-paying capacity of the company.
Price-to-Earnings (P/E) Ratio
Formula:
Market Price per Equity Share / EPS
The P/E ratio helps investors decide whether to buy a company’s shares. A lower P/E may indicate undervaluation; a higher P/E suggests growth expectations.
Gross Profit Ratio
Formula:
Gross Profit × 100 / Net Sales
This ratio indicates profit from operations before charging other expenses. It helps in price decisions and assessing operational margins.
Net Profit Ratio
Formula:
Net Operating Profit × 100 / Net Sales
Net profit ratio shows what percentage of sales translates to bottom-line profit after all expenses.
Solvency Ratios
Long-Term Solvency Ratios
Fixed Assets Ratio
Formula:
Fixed Assets / Long-Term Funds
This ratio should not exceed 1.0. If less than 1.0, it indicates that part of working capital is financed through long-term funds (core working capital).
Debt-to-Equity Ratio
Formula (version 1):
Total Long-Term Debt / Total Long-Term Funds
Formula (version 2):
Total Long-Term Debt / Shareholders’ Funds
Debt-to-equity measures financial leverage and shows the proportion of debt and equity used to finance assets. Lower ratios indicate conservative financing.
Debt Service Coverage Ratio (DSCR)
Formula:
Cash Profit Available for Debt Service / (Interest + Principal Instalment)
DSCR is critical for lenders to assess whether a borrower can service debt from operational cash flows. A ratio above 1.25 is generally acceptable to banks.
Short-Term/Liquidity Solvency Ratios
Current Ratio
Formula:
Current Assets / Current Liabilities
- Ideal ratio: 2.0
- Acceptable to banks: 1.33
The current ratio measures short-term liquidity and the firm’s ability to pay current liabilities with current assets.
Quick Ratio (Liquidity Ratio / Acid Test Ratio)
Formula:
Liquid Assets / Current Liabilities
The quick ratio excludes inventory (less liquid) from current assets, providing a stricter measure of liquidity.
Turnover/Activity Ratios
Stock Turnover Ratio
Formula:
Cost of Goods Sold / Average Inventory
Higher turnover indicates faster inventory movement and efficient inventory management.
Debtors Turnover Ratio (Debtors Velocity)
Formula:
Credit Sales / Average Accounts Receivable
This measures how quickly credit sales are converted to cash.
Debtors Collection Period
Formula (Method 1):
(Days or Months in Year) / Debtors Turnover
Formula (Method 2):
Accounts Receivable / Average Daily (or Monthly) Credit Sales
This ratio shows the average time taken to collect payment from debtors. Lower collection periods indicate efficient credit management.
Fixed Assets Turnover Ratio
Formula:
Cost of Goods Sold / Net Fixed Assets
(Use sales if COGS is unavailable.)
This indicates how efficiently the company uses its fixed assets to generate sales.
Worked Example: Ratio Calculation
Problem: Calculate the following ratios for year-end March 2026 and 2027:
- Return on Capital Employed
- Current Ratio
- Debt-to-Equity Ratio
- Fixed Assets Turnover Ratio
- Inventory Turnover Ratio
- Earnings Per Share
Balance Sheets as at 31st March (Rs. Lakhs)
| Liabilities | 2025 | 2026 | 2027 |
|---|---|---|---|
| Share Capital (Rs. 10 each) | 800 | 1,000 | 1,000 |
| Reserves & Surplus | 700 | 800 | 1,000 |
| Secured Term Loans | 800 | 2,000 | 2,400 |
| Cash Credit from Bank | 800 | 1,000 | 1,500 |
| Sundry Creditors | 1,200 | 900 | 1,100 |
| Total Liabilities | 4,300 | 5,700 | 7,000 |
Assets (as at 31st March, Rs. Lakhs)
| Assets | 2025 | 2026 | 2027 |
|---|---|---|---|
| Fixed Assets: | |||
| Gross Block | 2,800 | 3,000 | 4,000 |
| Less: Depreciation | 920 | 1,400 | 2,000 |
| Net Fixed Assets | 1,880 | 1,600 | 2,000 |
| Current Assets: | |||
| Stock | 1,520 | 2,400 | 2,800 |
| Debtors | 480 | 500 | 900 |
| Other Current Assets | 420 | 1,200 | 1,300 |
| Total Current Assets | 2,420 | 4,100 | 5,000 |
| Total Assets | 4,300 | 5,700 | 7,000 |
Solution:
1. Return on Capital Employed (ROCE) – March 2026
Capital Employed (2025): Rs. 2,300 Lakhs
Capital Employed (2026): Rs. 3,800 Lakhs
Average Capital Employed: (2,300 + 3,800) / 2 = 3,050 Lakhs
EBIT (2026): Rs. 1,020 Lakhs
ROCE = (1,020 / 3,050) × 100 = 33.44%
ROCE – March 2027
Capital Employed (2026): Rs. 3,800 Lakhs
Capital Employed (2027): Rs. 4,400 Lakhs
Average Capital Employed: (3,800 + 4,400) / 2 = 4,100 Lakhs
EBIT (2027): Rs. 1,800 Lakhs
ROCE = (1,800 / 4,100) × 100 = 43.90%
2. Current Ratio
| Year | Current Assets | Current Liabilities | Ratio |
|---|---|---|---|
| March 2026 | 4,100 | 1,900 | 2.16 |
| March 2027 | 5,000 | 2,600 | 1.92 |
Both ratios are above the bank-acceptable minimum of 1.33 and near or above the ideal ratio of 2.0.
3. Debt-to-Equity Ratio
| Year | Total Long-Term Debt | Total Long-Term Funds | D/E Ratio |
|---|---|---|---|
| March 2026 | 2,000 | 1,800 | 1.11 |
| March 2027 | 2,400 | 2,000 | 1.20 |
Both ratios indicate moderate leverage; the slight increase in 2027 shows slightly higher reliance on debt financing.
4. Fixed Assets Turnover Ratio
Average Net Fixed Assets (2026): (1,880 + 1,600) / 2 = 1,740 Lakhs
Cost of Goods Sold (2026): Rs. 4,800 Lakhs
Fixed Assets Turnover = 4,800 / 1,740 = 2.76
Average Net Fixed Assets (2027): (1,600 + 2,000) / 2 = 1,800 Lakhs
Cost of Goods Sold (2027): Rs. 7,200 Lakhs
Fixed Assets Turnover = 7,200 / 1,800 = 4.0
Improved turnover in 2027 indicates more efficient asset utilization.
5. Inventory Turnover Ratio
Average Inventory (2026): (1,520 + 2,400) / 2 = 1,960 Lakhs
Cost of Goods Sold (2026): Rs. 4,800 Lakhs
Inventory Turnover = 4,800 / 1,960 = 2.45
Average Inventory (2027): (2,400 + 2,800) / 2 = 2,600 Lakhs
Cost of Goods Sold (2027): Rs. 7,200 Lakhs
Inventory Turnover = 7,200 / 2,600 = 2.77
6. Earnings Per Share (EPS)
March 2026:
Net Profit after Tax: Rs. 300 Lakhs
Number of Equity Shares: 100 Lakhs
EPS = 300 / 100 = Rs. 3.00
March 2027:
Net Profit after Tax: Rs. 600 Lakhs
Number of Equity Shares: 100 Lakhs
EPS = 600 / 100 = Rs. 6.00
EPS doubled in 2027, reflecting improved profitability.
Frequently Asked Questions
1. What is the ideal current ratio for banks?
Banks typically consider a current ratio of 1.33 to 2.0 as acceptable. A ratio of 2.0 is considered ideal, indicating the company has Rs. 2 in current assets for every Re. 1 in current liabilities.
2. Why is ROCE important for credit analysis?
ROCE measures how effectively a company uses its capital to generate earnings. Higher ROCE indicates better operational efficiency and stronger ability to service debt, making it critical for assessing creditworthiness in lending decisions.
3. What does a debt-to-equity ratio of 1.2 indicate?
A ratio of 1.2 means the company has Rs. 1.20 in debt for every Re. 1 in equity. This indicates moderate leverage. Ratios above 2.0 may signal higher financial risk.
4. How do turnover ratios help in credit decisions?
Turnover ratios show how efficiently a company converts assets into sales. Higher inventory turnover and lower debtor collection periods indicate better working capital management and lower credit risk for lenders.
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