Commonly used ratios
This sub‑topic covers the most frequently tested financial ratios used by research analysts to evaluate a company's liquidity, leverage, profitability, efficiency and market valuation. Understanding these ratios helps you interpret balance‑sheet and income‑statement data, compare firms, and answer NISM exam questions accurately. The ratios are core tools for assessing risk and return in the Indian equity market.
Learning Objectives
- 1Identify and define the key categories of financial ratios.
- 2Calculate each ratio using the standard NISM formula.
- 3Interpret ratio values in the context of Indian companies and SEBI guidelines.
- 4Avoid common calculation traps that appear in the certification exam.
Liquidity Ratios
Liquidity ratios measure a company's ability to meet short‑term obligations using its most liquid assets. The two ratios most often asked in NISM are the Current Ratio and the Quick (Acid‑Test) Ratio. They are calculated from balance‑sheet items that Indian companies disclose quarterly and annually, making them easy to verify during an exam.
The Current Ratio compares total current assets to current liabilities. A value greater than 1 indicates that the firm has more short‑term assets than short‑term debts, which is generally viewed positively by lenders and investors. However, an excessively high ratio may signal inefficient use of cash.
The Quick Ratio refines the Current Ratio by removing inventory, because inventory may not be readily convertible to cash. This ratio is especially relevant for firms in sectors such as textiles or pharmaceuticals where inventory turnover can be slow. In the exam, you will often be asked to choose the more appropriate ratio for a given industry scenario.
- Current Ratio = Current Assets ÷ Current Liabilities
- Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
Where:
Current Assets= Total current assets in rupeesCurrent Liabilities= Total current liabilities in rupeesWorked Example
Given Current Assets = 5,00,000 and Current Liabilities = 2,50,000: Step 1: Current Ratio = 5,00,000 ÷ 2,50,000 Step 2: Current Ratio = 2.0 Verification: 5,00,000 ÷ 2,50,000 = 2.0.
Where:
Current Assets= Total current assets in rupeesInventory= Value of inventories in rupeesCurrent Liabilities= Total current liabilities in rupeesWorked Example
Given Current Assets = 5,00,000, Inventory = 1,20,000 and Current Liabilities = 2,50,000: Step 1: Quick Ratio = (5,00,000 – 1,20,000) ÷ 2,50,000 Step 2: Quick Ratio = 3,80,000 ÷ 2,50,000 = 1.52 Verification: (5,00,000 – 1,20,000) ÷ 2,50,000 = 1.52.
Students often plug the Current Ratio formula into a Quick Ratio question. Remember to subtract inventory first; otherwise you will overstate liquidity and lose marks.
Leverage Ratios
Leverage ratios assess the extent to which a company is financed by debt versus equity. The NISM syllabus emphasizes the Debt‑to‑Equity (D/E) ratio because it directly reflects the risk profile that SEBI expects analysts to evaluate.
A high D/E ratio suggests that a firm relies heavily on borrowed funds, which can amplify earnings but also increase vulnerability to interest rate changes and economic downturns. In Indian capital‑intensive sectors like infrastructure, a higher D/E may be justified, whereas in consumer‑goods firms a lower ratio is preferred.
During the exam you may be asked to compute D/E from balance‑sheet figures or to interpret a change in the ratio over two fiscal years. Pay attention to whether the question uses total debt (including long‑term and short‑term borrowings) or only long‑term debt, as the syllabus defines total debt for this ratio.
- Debt‑to‑Equity Ratio = Total Debt ÷ Shareholders' Equity
Where:
Total Debt= Sum of short‑term borrowings, long‑term debt, and other interest‑bearing liabilities (₹)Shareholders' Equity= Total equity attributable to shareholders (₹)Worked Example
Given Total Debt = 3,00,000 and Shareholders' Equity = 4,50,000: Step 1: D/E = 3,00,000 ÷ 4,50,000 Step 2: D/E = 0.67 Verification: 3,00,000 ÷ 4,50,000 = 0.67.
Do not replace Shareholders' Equity with Total Assets in the D/E formula. The ratio specifically compares debt to equity, not to the entire asset base.
Profitability Ratios
Profitability ratios reveal how efficiently a company converts revenue into profit and returns on capital. The NISM exam frequently tests Net Profit Margin (NPM) and Return on Equity (ROE) because they link the income statement with the balance sheet.
Net Profit Margin is expressed as a percentage of revenue. It shows the proportion of each rupee of sales that remains as profit after all expenses, taxes, and interest. A rising NPM indicates improving cost control or pricing power, both of which are attractive to investors.
Return on Equity measures the earnings generated per rupee of shareholders' equity. ROE is a key indicator of how well management uses the capital provided by owners. The exam often asks you to compute ROE using average equity, which smooths out balance‑sheet fluctuations across the period.
- Net Profit Margin = (Net Profit ÷ Revenue) × 100
- Return on Equity = (Net Profit ÷ Average Shareholders' Equity) × 100
Where:
Net Profit= Profit after tax and interest in rupeesRevenue= Total sales or operating revenue in rupeesWorked Example
Given Net Profit = 75,000 and Revenue = 5,00,000: Step 1: NPM = (75,000 ÷ 5,00,000) × 100 Step 2: NPM = 0.15 × 100 = 15% Verification: (75,000 ÷ 5,00,000) × 100 = 15%.
Where:
Net Profit= Profit after tax in rupees for the periodAverage Shareholders' Equity= (Equity at start + Equity at end) ÷ 2 in rupeesWorked Example
Given Net Profit = 80,000, Equity at start = 4,00,000 and Equity at end = 4,80,000: Step 1: Average Equity = (4,00,000 + 4,80,000) ÷ 2 = 4,40,000 Step 2: ROE = (80,000 ÷ 4,40,000) × 100 Step 3: ROE = 0.1818 × 100 ≈ 18.18% Verification: (80,000 ÷ 4,40,000) × 100 = 18.18%.
Efficiency Ratios
Efficiency ratios assess how well a company utilizes its assets to generate sales. The Asset Turnover Ratio is the primary efficiency metric in the NISM syllabus.
Asset Turnover is calculated by dividing net sales by average total assets. A higher ratio indicates that the firm is generating more revenue per rupee of assets, which is especially important for capital‑intensive industries such as manufacturing and utilities.
When the exam provides beginning and ending asset figures, always compute the average to avoid overstating turnover. Remember that the ratio is unit‑less, allowing you to compare firms of different sizes.
- Asset Turnover Ratio = Net Sales ÷ Average Total Assets
Where:
Net Sales= Revenue from operations after returns and allowances in rupeesAverage Total Assets= (Total assets at start + Total assets at end) ÷ 2 in rupeesWorked Example
Given Net Sales = 12,00,000, Assets at start = 8,00,000 and Assets at end = 9,20,000: Step 1: Average Assets = (8,00,000 + 9,20,000) ÷ 2 = 8,60,000 Step 2: Asset Turnover = 12,00,000 ÷ 8,60,000 ≈ 1.395 Verification: 12,00,000 ÷ 8,60,000 = 1.395.
Market Ratios
Market ratios link a company's financial performance with its market price. The Price‑Earnings (P/E) ratio is the most frequently asked market ratio in the NISM exam.
P/E compares the current market price per share with earnings per share (EPS). A high P/E may indicate that investors expect strong future growth, while a low P/E could signal undervaluation or poor prospects. In the Indian context, SEBI requires listed companies to disclose EPS, making the ratio easy to compute.
When the exam presents a scenario with market price and EPS, use the straightforward P/E formula. Do not confuse it with the earnings yield, which is the inverse of P/E.
- Price‑Earnings Ratio = Market Price per Share ÷ Earnings per Share
Where:
Market Price per Share= Current trading price of one share in rupeesEarnings per Share= Net profit attributable to equity shareholders divided by total number of shares, in rupeesWorked Example
Given Market Price = 150 ₹ and EPS = 12.5 ₹: Step 1: P/E = 150 ÷ 12.5 Step 2: P/E = 12 Verification: 150 ÷ 12.5 = 12.
Summary of Commonly Used Ratios
| Ratio Category | Ratio Name | Key Formula | Typical Interpretation |
|---|---|---|---|
| Liquidity | Current Ratio | Current Assets ÷ Current Liabilities | >1 indicates adequate short‑term coverage |
| Liquidity | Quick Ratio | (Current Assets – Inventory) ÷ Current Liabilities | >1 shows strong immediate liquidity |
| Leverage | Debt‑to‑Equity | Total Debt ÷ Shareholders' Equity | Higher values = more financial risk |
| Profitability | Net Profit Margin | (Net Profit ÷ Revenue) × 100 | Higher % = better cost control |
| Profitability | Return on Equity | (Net Profit ÷ Avg. Equity) × 100 | Higher % = efficient use of equity |
| Efficiency | Asset Turnover | Net Sales ÷ Avg. Total Assets | Higher = better asset utilisation |
| Market | P/E Ratio | Market Price per Share ÷ EPS | Higher = growth expectations, lower = possible undervaluation |
Average Return on Equity (ROE) Across Four Indian Sectors (2023)
Scenario
An analyst is evaluating XYZ Ltd. for a client. The company reported Net Profit of ₹1,20,000 for FY 2022‑23. Shareholders' equity at the beginning of the year was ₹4,00,000 and at the end was ₹5,00,000. The exam asks for the ROE for the year.
Solution
Step 1: Compute average equity = (4,00,000 + 5,00,000) ÷ 2 = 4,50,000. Step 2: Apply the ROE formula: ROE = (1,20,000 ÷ 4,50,000) × 100 = 0.2667 × 100 ≈ 26.67%. Step 3: Since the result is above 20%, the analyst may conclude that XYZ Ltd. is generating strong returns on the capital provided by shareholders, a point that could be highlighted in the research report.
Conclusion
The key exam takeaway is to always use average equity for ROE, not the year‑end figure, to avoid overstating the return.
For ratios that involve balance‑sheet items (ROE, Asset Turnover), the NISM syllabus mandates using the average of the opening and closing balances. Forgetting this step leads to a common 5‑10% error.
⭐Exam Takeaways
- Liquidity ratios (Current, Quick) assess short‑term solvency; Quick Ratio excludes inventory.
- Leverage is measured by Debt‑to‑Equity; use total debt and shareholders' equity as defined in the balance sheet.
- Profitability ratios include Net Profit Margin (percentage of revenue) and ROE (uses average equity).
- Efficiency is captured by Asset Turnover, which uses average total assets to smooth balance‑sheet fluctuations.
- Market valuation uses the P/E ratio; a higher P/E signals growth expectations, while a lower P/E may indicate undervaluation.
- Always apply the average‑balance method for ratios that combine income‑statement and balance‑sheet figures.
- Watch out for common traps: forgetting to subtract inventory for Quick Ratio, or substituting equity with total assets in D/E.
- Remember that all ratios are unit‑less percentages or multiples, enabling comparison across Indian companies of different sizes.
Practice Questions
8 questions on Commonly used ratios
What does a Current Ratio greater than 1 indicate?
Which ratio excludes inventory from its calculation?
An analyst is evaluating two textile companies. Which ratio is most appropriate to assess their short‑term liquidity?
If Total Debt is ₹3,00,000 and Shareholders' Equity is ₹4,50,000, what is the Debt‑to‑Equity ratio?
Company X has Current Assets ₹5,00,000, Inventory ₹1,20,000 and Current Liabilities ₹2,50,000. Which statement correctly describes its ratios?
A firm reports Net Profit ₹80,000, opening equity ₹4,00,000 and closing equity ₹4,80,000. What is its ROE (to two decimal places)?
Which statement about the Asset Turnover ratio is correct?
The Price‑Earnings (P/E) ratio is calculated by dividing which two items?