Definition: The Return on Equity Ratio shows how efficiently the company utilizes the shareholder’s money in generating the revenues for the firm. The investors are more concerned with this ratio, as they want to see how their funds are being utilized by the company.

The return on equity ratio can be used by the company internally or by the investors to evaluate the effectiveness of the management in generating the profits relative to the shareholder’s funds. Ideally, the ROE should be compared with the other companies within the same industry because of the same business environment and the common customer base.

The formula to calculate Return on Equity ratio is:

Return on Equity Ratio = Net income / Average Shareholder’s Equity

Where, Net income = profit after tax and the Average shareholder’s equity = (Shareholder equity at the beginning + shareholder equity at the end of the financial year) / 2

A Higher value of return on equity ratio shows the better utilization of shareholder’s fund and a firm is able to generate more revenues without raising the additional capital.

Example: Suppose the shareholder’s equity as on 1 July 2013 and on 30 June 2014 were Rs 3,00,000 and Rs 2,50,000 respectively. The firm earned the revenues of Rs 50,000. Then return on equity will be:

ROE = 50,000/ 2,75,000 = 0.18 or 18%
[ Average shareholder equity =( 3,00,000 + 2,50,000)/2 = 2,75,000]

Definition: The Return on Capital Employed Ratio measures the profits generated from each capital employed. Unlike return on equity that measures only the company’s common equity, the return on capital employed is a comprehensive approach that measures the overall financial performance of the company, by taking both the equity and the liabilities into consideration.

The return on capital employed is best suited when comparing the performance of the companies in the capital- intensive industries.The company’s return should be more than the rate at which the funds are borrowed from the investors.

The formula to calculate this ratio is:

Return on Capital Employed = Net Operating Profit/ Capital Employed

Where, Net Operating Profit is equivalent to earnings before interest and taxes (EBIT) and Capital Employed = Total Assets – Current Liabilities or shareholder’s equity – long-term liabilities.

A Higher value of return on capital employed ratio shows more revenue is generated with the capital employed and hence better returns are given to the investors.

Example: Suppose a firm has a net operating profit of Rs 25,000 and has reported Rs 1,50,000 and Rs 50,000 as total assets and current liabilities respectively. Then the Return on Capital Employed will be:

Return on Capital Employed = 25,000/1,00,000 = 0.25 or 25%
[ Capital employed = 1,50,000 – 50,000 = 1,00,000]

Definition: The Current Ratio is the part of the liquidity ratio that helps to determine the firm’s ability to pay off its short-term obligations with its Current Assets. Simply, a firm uses the current assets, such as cash, cash equivalents, marketable securities, bills receivables, etc. to meet its short-term debt.

Generally, the current assets more than twice the current liabilities are considered favorable, as it shows the firm’s readiness to meet its obligations when they arise. Current liabilities are generally the obligations that are expected to become due within 12 months, and these are in the form of loans and advances, creditors, bills payable, etc.

An ideal way to judge the performance of the company is to compare its current ratio with the other companies within the same industry. This ratio helps the firm to determine its efficiency to pay for the current debt as well as helps in the planning of future payments on the basis of the trend followed by the current ratios calculated in the past 5 to 7 years.

The formula for calculating the current ratio:

Current Ratio = Current Asset/ Current Liabilities

The Higher value of current ratio shows the readiness of a firm to pay for its current obligations when they arise. Thus, higher the ratio higher is the liquidity of the firm.

Example: Suppose a firm has its current assets and current liabilities worth Rs 15,00,000 and Rs 5,00,000 respectively. Then the current Ratio of the firm will be:

Current Ratio = 15,00,000/5,00,000 = 3:1

Definition: The Acid Test Ratio also referred to as a Quick Ratio is calculated to determine the ability of a firm to pay off its current liabilities with Quick Assets. What are Quick Assets? The quick assets are the current assets that are highly liquid and can be converted into cash within 90 days or in a short period of time.

Generally, all the current assets are the quick assets, but however, the inventory is subtracted from its value because inventories are not readily convertible into cash. The acid-test ratio is a key indicator for the investor to know if the firm is capable of paying its short-term bills on time.

Ideally, the quick ratio equal to or more than 1 is considered favorable; that shows the company is having more liquid assets and do not rely heavily on the inventories. The formula for computing the Acid-test Ratio is:

Acid-test Ratio = Quick Asset/ Current Liabilities

Higher the Acid-test Ratio, the higher is the debt-paying capacity of a firm.

Example: Suppose a firm has a cash balance of Rs 50,000, the marketable securities worth Rs 10,000, and account receivables amounting to Rs 1,00,000 (inclusive of inventories worth Rs 40,000). The current liabilities are Rs 60,000. Then the Acid test ratio will be:

Acid-test Ratio = 1,20,000/60,000 = 2:1

[Quick Asset = (50,000+10,000+1,00,000) – 60,000 = 1,20,000]

Definition: The Cash Ratio shows how quickly the firm can pay off its liabilities relative to Cash, bank balances, marketable securities since these are considered as the most liquid component of the current assets. Simply, this ratio measures the ability of a firm to meet its current obligations with the cash or cash equivalents.

It is the most stringent liquidity ratio and is considered as an important decision factor for the creditors regarding how much amount is to be lent to the asking firm. The high value of cash ratio shows sufficient cash balance with the firm and is capable of paying the current debts. The formula for calculating the Cash Ratio is:

Cash Ratio = (Cash and Bank Balances+ Current Investments) / Current Liabilities

A Higher value of ratio results in more lending from the creditors due to a safety of returns.

Example: Suppose a firm’s cash balance is Rs 50,000, cash equivalents worth Rs 15,000 and the current liabilities comprising of bills payable, current long term liabilities and current taxes amounting to Rs 7,000, 10,000 and 3,000 respectively. Then the Cash ratio will be:
= 75,000/20,000 = 3.75 : 1

cash = 50,000+15,000 =75,000
Current liabilities= 7,000+10,000+3,000 = 20,000

Definition: The Inventory Turnover Ratio, also called as Stock Turnover Ratio, shows how frequently the inventory is converted into the sales. Simply, this ratio measures the capacity of a firm to generate revenues from the sale of its inventory.

Ideally, the company’s inventory turnover ratio should be compared with the industry average. But however, companies do evaluate their performances against the previous ratios or the planned ratios. The formula to compute the Inventory Turnover Ratio is:

Inventory Turnover Ratio= Cost of goods sold/ Average inventory

Where, Cost of goods sold= (Opening stock + Purchases + Direct expenses and wages + Carriage Inward) – Closing Stock
Average Inventory = (Opening stock + Closing Stock) /2

Note: In case cost of goods sold is not given, the sales amount can be used in its position.

Higher the inventory turnover ratio better is the inventory management of the firm and ensures timely delivery of products to the customers.

Example: Suppose a firm is having an opening stock and a closing stock worth Rs 1,20,000 and 30,000 respectively. The firm incurred the direct expenses of Rs 50,000, then the inventory turnover ratio will be:

Inventory Turnover Ratio = 1,40,000/75,0000 = 1.87 times

Cost of goods sold = (1,20,000+50,000) – 30,000 = 1,40,000
Average Inventory = 1,20,000+30,000 = 75,000

Definition: The Debtors Turnover Ratio also called as Receivables Turnover Ratio shows how quickly the credit sales are converted into the cash. This ratio measures the efficiency of a firm in managing and collecting the credit issued to the customers.

One important thing that needs to be taken care of is, generally the companies use total sales in the place of net sales, which gives an inflated turnover ratio. Thus, while calculating this ratio, only the net credit sales is to be taken into consideration.

Ideally, a company compares its debtors turnover ratio with the companies that have similar business operations and revenue and lie within the same industry The formula to compute Debtors Turnover Ratio is:

Debtors Turnover Ratio = Net Credit Sales/Average Account Receivable.

Where, Average Account Receivable includes trade debtors and bill receivables.

Higher the Debtors turnover ratio, better is the credit management of the firm.

Example: Suppose a firm has total sales of Rs 5,00,00 out of which the credit sales are Rs 2,50,000. The opening balance of account receivables is Rs 2,00,000 and the closing balance at the end of financial year is Rs 1,00,000. The debtors turnover ratio will be:

Debtors Turnover Ratio = 2,50,000/1,50,000 = 1.67 times

Credit sales = 2,50,000
Average Account Receivables = (2,00,000+1,00,000) /2 = 1,50,000

Definition: The Average Collection Period, also called as Debt Collection Period, shows how much time business takes to realize the credit sales. Simply, how long will it take to recover payments from the debtors against the credit sales?

This period encompasses the duration when the credit was given to the customer or client and the date when the cash was realized against it. The formula to compute this ratio is:

Average Collection period = Days in a year / Debtors Turnover Ratio

The efficiency of the collection period can be assessed by comparing the average against the credit period allowed to the customers.

Note: Generally, 365 days are considered

Example: Suppose a firm has a credit sales of Rs 5,00,000 and the average account receivables is Rs 1,00,000, then

Average Collection Period = 365/5 = 73 days

Debtors Turnover Ratio = 5,00,000/1,00,000 = 5

Definition: The Fixed Assets Turnover Ratio shows, how efficiently the fixed assets are used to generate sales. Simply, this ratio shows the efficiency of a firm in generating profits relative to the investments in the fixed assets.

The fixed assets turnover ratio is suitable for the heavy industries where huge capital is employed in the investments such as manufacturing. Thus, the ratio should be compared with the companies within the specific industries.

Also, the companies should keep in mind; that accelerated depreciation can inflate the value of the ratio, due to the reduced value of the denominator. To overcome this problem, the company should reinvest in other investments to compensate the older assets.

The formula to compute this ratio is:

Fixed Assets Turnover Ratio = Net Sales/ Gross Fixed Assets – Accumulated Depreciation

Higher the ratio, the better is the utilization of fixed assets. This means a firm is able to generate sales with the limited amount of fixed assets without raising any additional capital.

Example: Suppose a firm has a gross fixed assets worth Rs 10,00,000 with the accumulated depreciation of Rs 2,00,000. The sales for the year is Rs 12,00,000. Then the Fixed Assets Turnover Ratio will be:

Fixed Assets Turnover Ratio = 12,00,000/ (10,00,000 – 2,00,000) = 1.5 times

Definition: The Total Assets Turnover Ratio shows how efficiently the total assets of the firm are employed to generate sales. This ratio gives an idea to the investor and the creditor about how the firm is managed, and the assets are utilized to generate revenues.

Ideally, the firm’s asset turnover ratio is compared with the other companies within the same industry because of the same business operations and the similar amount of investments made in the fixed assets.

The formula to compute this ratio is:

Total Assets Turnover Ratio= Net Sales/ Average Total Assets

The higher the ratio, the better is the utilization of total assets in the firm. This shows that a firm is able to generate revenues with the minimum amount of total assets without raising an additional capital.

Example: Suppose a firm has a net sales of Rs 50,000 and the opening and closing balance of the assets is Rs 1,00,000 and 50,000 respectively. The Total Assets Turnover Ratio will be:

Total Assets Turnover Ratio = 50,000/75000 = 0.67 times

Average Total Assets = (1,00,000+50,000)/2 =75,000