Engineering Economics

- Chandra Sekara Raju Vijayabattu

FINANCIAL MANAGEMENT
I. INTRODUCTION

1.1 FINANCE
Finance is the life blood of business. Finance may be defined as the
art and science of managing money. Finance also is referred as the
provision of money at the time when it is needed. Finance function is the
procurement of funds and their effective utilization in business concerns.
The term financial management has been defined by Solomon, “It is
concerned with the efficient use of an important economic resource
namely, capital funds”. The most popular and acceptable definition of
financial management as given by S. C. Kuchal is that “Financial
Management deals with procurement of funds and their effective
utilization in the business. Financial management is the operational
activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations. Thus, Financial
Management is mainly concerned with the effective funds management in
the business.
Financial management is that activity of management which is
concerned with the planning, procuring and controlling of the firm's
financial resources. It means applying general management principles to
financial resources of the institutions. Financial activities of an
institutions is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager
performs all the requisite financial activities. A financial manager is a
person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in
order to ensure that the funds are utilized in the most efficient manner.
His actions directly affect the Profitability, growth and goodwill of the firm.
The scope and coverage of financial management have undergone
fundamental changes over the last half a century. During 1930s and
1940s, it was concerned of raising adequate funds and maintaining
liquidity and sound financial structure. This is known as the 'Traditional
Approach' to procurement and utilization of funds required by a firm.
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Thus, it was regarded as an art and science of raising and spending of

funds. The traditional approach emphasized the acquisition of funds and
ignored efficient allocation and constructive use of funds. It does not give
sufficient attention to the management of working capital.
During 1950s, the need for most profitable allocation of scarce capital
resources was recognized. During 1960s and 1970s many analytical tools
and concepts like funds flow statement, ratio analysis, cost of capital,
earning per share, optimum capital structure, portfolio theory etc. were
emphasized. As a result, a broader concept of finance began to be used.
Thus, the modern approach to finance emphasizes the proper allocation
and utilization of funds in addition to their economical procurement. Thus,
business finance is defined as" the activity concerned with the planning,
raising, controlling and administering of funds used in the business."
Modern business finance includes –
(i) Determining the capital requirements of the firm.
(ii) Raising of sufficient funds to make an ideal or optimum capital structure
(iii) Allocating the funds among various types of assets
(iv) Financial control so as to ensure efficient use of funds.

1.2 DEFINITION OF FINANCIAL MANAGEMENT

“Financial management is the activity concerned with planning, raising,
controlling and administering of funds used in the business.” – Guthman
and Dougal
“Financial management is that area of business management devoted to a
judicious use of capital and a careful selection of the source of capital in
order to enable a spending unit to move in the direction of reaching the
goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.”- Massie

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NATURE OF FINANCIAL MANAGEMENT

1. Financial Management is an integral part of overall management.
Financial considerations are involved in all business decisions. So
financial management is pervasive throughout the organisation.
2. In most of the organizations, financial operations are centralized. This
results in economies.
3. Financial management involves with data analysis for use in decision
making.
4. The central focus of financial management is valuation of the firm. That
is financial decisions are directed at increasing/maximization/ optimizing
the value of the firm.
5. Financial management essentially involves risk-return trade-off Decisions
on investment involve choosing of types of assets which generate returns
accompanied by risks. Generally higher the risk, returns might be higher
and vice versa. So, the financial manager has to decide the level of risk the
firm can assume and satisfy with the accompanying return.
6. Financial management affects the survival, growth and vitality of the firm.
Finance is said to be the life blood of business. It is to business, what blood
is to us. The amount, type, sources, conditions and cost of finance
squarely influence the functioning of the unit.
7. Finance functions, i.e., investment, rising of capital, distribution of profit,
are performed in all firms - business or non-business, big or small,
proprietary or corporate undertakings.
8. Financial management is a sub-system of the business system which has
other subsystems like production, marketing, etc. In systems arrangement
financial sub- system is to be well-coordinated with others and other sub-
systems.
9. Financial Management is the activity concerned with the control and
planning of financial resources.
10. Financial management is multi-disciplinary in approach. It
depends on other disciplines, like Economics, Accounting etc., for a better
procurement and utilisation of finances.

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OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit maximization
It is commonly believed that a shareholders objective is to maximise profit. To
achieve the goal of profit maximisation, the financial manager takes only those
actions that are expected to make a major contribution to the firm's overall
profits. The total earnings available for the firm's shareholders is commonly
measured in terms of earnings per share (EPS). Hence the decisions and
actions of finance managers should result in higher earnings per share for
shareholders.
Points in favour of profit maximisation:
• It is a parameter to measure the performance of a business
• It ensures maximum welfare to the shareholders, employees and prompt
payment to the creditors
• Increase the confidence of management in expansion and diversification.
• It indicates the efficient use of funds for different requirements.
Points against profit maximisation:
• It is not a clear term like accounting profit, before tax or after tax or net profit
or gross profit.
• It encourage corrupt practices
• It does not consider the element of risk
• Time value of money is not reflected
• Attracts cut –throat competition
• Huge profits attracts government intervention
• It invites problem from workers.
• It affects the long run liquidity of a company.

2. Wealth Maximisation
The goal of the finance function is to maximise the wealth of the owners for
whom the firm is being carried on. The wealth of corporate owners is measured
by the share prices of the stock, which is turn is based on the timing of return,
cash flows and risk. While taking decisions, only that action that is expected
to increase share price should be taken.
It considers :
(a) Time value of money on investment decision
(b) The risk or uncertainty of future earnings and
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(c) effects of dividend policy on the market price of shares.

Points In favour of Wealth Maximisation

• It is a clear term
• Net effect of investment and benefits can be measured clearly.
• It considers the time value for money.
• It should be accepted universally
• It guides the management in framing a consistent strong dividend policy
to reach maximum return to the equity holders
Points against wealth maximisation:
• This concept is useful for equity share holders not for debenture holders
• The expectations of workers, consumers and various interest groups
create a greater influence that must be respected to achieve long run
wealth maximization and also for their survival.
Basis Wealth Maximization Profit Maximization

It is defined as the
management of financial It is defined as the management of
Definiti resources aimed at financial resources aimed at
on increasing the value of the increasing the profit of the
stakeholders of the company. company.

Focuses on increasing the

Focus value of the stakeholders of Focuses on increasing the profit of
the company in the long the company in the short term.
term.
It considers the risks and It does not consider the risks and
uncertainty inherent in the uncertainty inherent in the
Risk business model of the business model of the company.
company.

It helps in achieving a larger

value of a company‟s worth It helps in achieving efficiency in
Usage which may reflect in the the company‟s day-to-day
increased market share of operations to make the business
the company. profitable.

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1.1 SCOPE OF FINANCIAL MANAGEMENT

Investment Decisions:
Managers need to decide on the amount of investment available out of the
existing finance, on a long-term and short-term basis. They are of two types:
Long- term investment decisions or Capital Budgeting mean committing
funds for a long period of time like fixed assets. These decisions are
irreversible and usually include the ones pertaining to investing in a building
and/or land, acquiring new plants/machinery or replacing the old ones, etc.
These decisions determine the financial pursuits and performance of a
business. Short-term investment decisions or Working Capital Management
means committing funds for a short period of time like current assets. These
involve decisions pertaining to the investment of funds in the inventory, cash,
bank deposits, and other short- term investments. They directly affect the
liquidity and performance of the business.

Financing Decisions:
Managers also make decisions pertaining to raising finance from long- term
sources and short-term sources. They are of two types:

Financial Planning decisions which relate to estimating the sources and

application of funds. It means pre-estimating financial needs of an
organization to ensure the availability of adequate finance. The primary
objective of financial planning is to plan and ensure that the funds are
available as and when required.

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Capital Structure decisions

which involve identifying sources of funds. They also involve decisions with
respect to choosing external sources like issuing shares, bonds, borrowing
from banks or internal sources like retained earnings for raising funds. The
decisions are made in the light of the cost of capital, risk factor involved and
returns to the shareholders.
Dividend Decisions:
These involve decisions related to the portion of profits that will be distributed
as dividend. Dividend is that portion of divisible profits that is distributed to
the owners i.e. the shareholders. Retained earnings is the proportion of profits
kept in, that is, reinvested in the business for the business. Shareholders
always demand a higher dividend, while the management would want to
retain profits for business needs. Dividend decision is to whether to distribute
earnings to shareholder as dividends or retain earnings to finance long-term
profits of the firm. It must be done keeping in mind the firms overall objective
of maximizing the shareholders wealth.

Cash Flows – Inflows & Outflows

1. Operating
2. Financing
3. Investing

Recurring & Non-recurring

1. Recurring - a recurring transaction is a type of charge or payment that is
borne by a cardholder regularly at specified intervals for an ongoing service
or product
2. Non-recurring - A non-recurring payment means a one-off transaction. It
usually happens just once, and there's generally just one invoice or bill
involved.

Revenues & Expenses

1. Revenue is the money generated from normal business operations, calculated
as the average sales price times the number of units sold. It is the top line (or
gross income) figure from which costs are subtracted to determine net income.
Revenue is also known as sales on the income statement.
2. An expense is the cost of operations that a company incurs to generate
revenue. It is simply defined as the cost one is required to spend on obtaining
something. As the popular saying goes, “it costs money to make money.”

Income Statement – P & L A/c

Classification of Assets & Liabilities - The Balance Sheet

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A share represents a unit of equity ownership in a company. Shareholders are

entitled to any profits that the company may earn in the form of dividends.
They are also the bearers of any losses that the company may face. In simple
words, if you are a shareholder of a company, you hold a percentage of
ownership of the issuing company in proportion to the shares you have
bought, often managed through a share market app.

Shares can be further categorized into two types. These are:

Equity shares
Preference shares

A company may issue different types (also known as “classes”) of shares.

These can include:

1. Ordinary Shares

Ordinary shares are the most common type of shares. They typically carry
voting rights but do not give shareholders rights to receive or demand for
dividends.

Ordinary shareholders also receive less dividends compared to shareholders

who hold preference shares. Companies may divide their ordinary shares into
different classes (e.g. “A” and “B”) with different rights attached to each class.

2. Preference Shares

Preference shares confer some preferential rights on the holder, superior to

ordinary shares. Normally, the preferential rights are the rights to fixed
dividends, priority to dividends over ordinary shares and to a return of capital
when the company goes into liquidation.

3. Redeemable Preference Shares

Redeemable preference shares allow for the repayment of the principal share
capital to shareholders. The company may redeem these shares at an agreed
value on a specified date or at the discretion of the directors. This is on the
condition that the company is a going concern.

Any redemptions can be paid out of the company’s capital using proceeds
from a fresh issue of shares. The directors must lodge a solvency statement
with ACRA under the “Notice of Redemption of Redeemable Preference Shares”

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4. Convertible Preference Shares

Convertible preference shares usually carry rights to a fixed dividend for a

particular term. At the end of the term, the company can choose to convert it
into ordinary shares or leave them as they are. Conversion prices must be
specified in the company’s constitution. If the price of an ordinary share rises,
the conversion prices will not follow. It is essentially allowing the shareholder
to purchase ordinary shares at a lower price. The relevant transaction in
BizFile+ is “Conversion of Shares”.

5. Treasury Shares

Treasury shares are ordinary shares which the company acquired from
shareholders. While the company is listed as the owner of the treasury shares,
it is not allowed to exercise the right to attend or vote at meetings, and no
dividends may be paid to the company.

The total number of treasury shares held by the company is capped at 10%
of the total number of ordinary shares issued. Any excess treasury shares (i.e.
more than 10% of the total number of ordinary shares) must be cancelled or
disposed of within 6 months.

Classification Of Equity Shares based on Share Capital

Here is a look at the classification of equity shares based on share capital:

• Authorised Share Capital: Every company, in its Memorandum of

Associations, requires to prescribe the maximum amount of capital that
can be raised by issuing equity shares. The limit, however, can be
increased by paying additional fees and after the completion of certain
legal procedures.
• Issued Share Capital: This implies the specified portion of the
company’s capital, which has been offered to investors through the
issuance of equity shares. For example, if the nominal value of one
stock is Rs 200 and the company issues 20,000 equity shares, the
issued share capital will be Rs 40 lakh.
• Subscribed Share Capital: The portion of the issued capital, which has
been subscribed by investors is known as subscribed share capital.

• Paid-Up Capital: The amount of money paid by investors for holding

the company’s stocks is known as paid-up capital. As investors pay the
entire amount at once, subscribed and paid-up capital refer to the same
amount.

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Classification Of Equity Shares based on Definition

Here is a look at the equity share classification based on the definition:

• Bonus Shares: Bonus share definition implies those additional stocks

which are issued to existing shareholders free-of-cost, or as a bonus.
• Rights Shares: Right shares meaning is that a company can provide
new shares to its existing shareholders - at a particular price and within
a specific period - before being offered for trading in stock markets.
• Sweat Equity Shares: If as an employee of the company, you have
made a significant contribution, the company can reward you by
issuing sweat equity shares.
• Voting And Non-Voting Shares: Although the majority of shares carry
voting rights, the company can make an exception and issue differential
or zero voting rights to shareholders.

Classification Of Equity Shares based on Returns

Based on returns, here is a look at the types of shares:

• Dividend Shares: A company can choose to pay dividends in the form

of issuing new shares, on a pro-rata basis.
• Growth Shares: These types of shares are associated with companies
that have extraordinary growth rates. While such companies might not
provide dividends, the value of their stocks increases rapidly, thereby
providing capital gains to investors.
• Value Shares: These types of shares are traded in stock markets at
prices lower than their intrinsic value. Investors can expect the prices
to appreciate over some time, thus providing them with a better share
price.

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Meaning, Significance and Objectives of Financial Analysis

Preparation of the final accounts is not the end of the accounting process. It
is followed by the analysis of these final accounts. Let us learn more about
the meaning, importance and the objectives of financial analysis.

Meaning
The process of reviewing and analyzing a company’s financial statements to
make better economic decisions is called analysis of financial statements. In
other words, the process of determining financial strengths and weaknesses
of the entity by establishing the strategic relationship between the items of
the balance sheet, profit and loss account, and other financial statements.

The term ‘analysis’ means the simplification of financial data by methodical

classification of the data given in the financial statements, ‘interpretation’
means, ‘explaining the meaning and significance of the data so simplified.’
However, both’ analysis and interpretation’ are interlinked and
complementary to each other.

Significance of Financial Analysis

Finance Manager
Analysis of financial statements helps the finance manager in:
• Assessing the operational efficiency and managerial effectiveness of the
company.
• Analyzing the financial strengths and weaknesses and creditworthiness of
the company.
• Analyzing the current position of financial analysis,
• Assessing the types of assets owned by a business enterprise and the
liabilities which are due to the enterprise.
• Providing information about the cash position company is holding and
how much debt the company has in relation to equity.
• Studying the reasonability of stock and debtors held by the company.

Top Management
Financial analysis helps the top management
• To assess whether the resources of the firm are used in the most efficient
manner
• Whether the financial condition of the firm is sound
• To determine the success of the company’s operations
• Appraising the individual’s performance
• evaluating the system of internal control
• To investigate the future prospects of the enterprise.

Trade Payables
Trade payables analyze of financial statements for:
• Appraising the ability of the company to meet its short-term obligations
Judging the probability of firm’s continued ability to meet all its financial
obligations in the future.

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• Firm’s ability to meet claims of creditors over a very short period of time.
• Evaluating the financial position and ability to pay off the concerns.

Lenders
Suppliers of long-term debt are concerned with the firm’s long-term solvency
and survival. They analyze the firm’s financial statements
• To ascertain the profitability of the company over a period of time,
• For determining a company’s ability to generate cash, to pay interest and
repay the principal amount
• To assess the relationship between various sources of funds (i.e. capital
structure relationships)
• To assess financial statements which contain information on past
performances and interpret it as a basis for forecasting future rates of
return and for assessing risk.
• For determining credit risk, deciding the terms and conditions of a loan if
sanctioned, interest rate, and maturity date etc.

Investors
Investors, who have invested their money in the firm’s shares, are interested
in the firm’s earnings and future profitability. Financial statement analysis
helps them in predicting the bankruptcy and failure probability of business
enterprises. After being aware of the probable failure, investors can take
preventive measures to avoid/minimize losses.

Labour Unions
Labour unions analyze the financial statements:
• To assess whether an enterprise can increase their pay.
• To check whether an enterprise can increase productivity or raise the
prices of products/ services to absorb a wage increase.

S.No. Users Objectives Ratios used in general

1. Shareholders Being owners of the Mainly Profitability
organisation they are Ratios [In particularEarning
interested to know about per share (EPS), Dividend
profitability and growth of per share (DPS), Price
theorganization Earnings (P/E), Dividend
Payout ratio (DP)]
2. Investors They are interested to know  Profitability Ratios
overall financial health of  Capital structure
the organisation particularly Ratios
future perspective of the
 Solvency Ratios
organisations.
 Turnover Ratios

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3. Lenders They will keep an eye on  Coverage Ratios

the safety perspective of  Solvency Ratios
their money lent to the
 Turnover Ratios
organisation
 Profitability Ratios
4. Creditors They are interested to know  Liquidity Ratios
liability position of the  Short term solvency
organisation particularly in Ratios/ LiquidityRatios
short term. Creditors would
like to know whether the
organisation will be able to
pay the amount on due date.

5. Employees They will be interested to  Liquidity Ratios

know the overall financial  Long terms solvency
wealth of the organization Ratios
and compare it with
 Profitability Ratios
competitor company.
 Return on
investment
6. Regulator / They will analyse the  Profitability Ratios
Government financial statements to
determine taxations and
other details payable to
the government.

7. Managers

(a) Production They are interested to know  Input output Ratio

Managers about data regarding input
 Raw material
output, production
consumption ratio.
quantitiesetc.

(b) Sales Data related to units sold  Turnover ratios

Managers for various years, other (basically receivable
associated figures and turnover ratio)
predicted future sales figure  Expenses Ratios
will be an area of interest
for them

(c) Financial They are interested to know  Profitability Ratios

Manager various ratios for their (particularly related to
future predictions of Return oninvestment)
financial requirement.  Turnover ratios
 Capital StructureRatios

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(d) Chief They will try to assess the  All Ratios

Executive/ General complete perspective of the
Manager company, starting from
Sales, Finance, Inventory,
Human resources,
Production etc.
8. Different Industry
 Ratio related to ‘call’
(a) Telecom  Revenue and
expenses per
customer

(b) Bank  Loan to deposit

Ratios
Finance Manager/
 Operating expensesand
Analyst will calculate ratios
income ratios
of their company and
compare it with Industry
(c) Hotel norms.  Room occupancy
ratio
 Bed occupancy
Ratios

(d) Transport  Passenger-kilometre

 Operating cost-per
passenger kilometre

Objectives of Financial Analysis

Let us look at some of the main objectives of financial analysis,

• Reviewing the performance of a company over the past periods:

To predict the future prospects of the company, past performance is
analyzed. Past performance is analyzed by reviewing the trend of past
sales, profitability, cash flows, return on investment, debt-equity
structure and operating expenses, etc.
• Assessing the current position & operational efficiency:
Examining the current profitability & operational efficiency of the
enterprise so that the financial health of the company can be determined.
For long-term decision making, assets & liabilities of the company are
reviewed. Analysis helps in finding out the earning capacity & operating
performance of the company.
• Predicting growth & profitability prospects:
The top management is concerned with future prospects of the company.
Financial analysis helps them in reviewing the investment alternatives for
judging the earning potential of the enterprise. With the help of financial
statement analysis, assessment and prediction of the bankruptcy and
probability of business failure can be done.

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• Loan Decision by Financial Institutions and Banks:

Financial analysis helps the financial institutions, loan agencies & banks
to decide whether a loan can be given to the company or not. It helps them
in determining the credit risk, deciding the terms and conditions of a loan
if sanctioned, interest rate, maturity date etc.

Ratio Analysis
Ratio analysis is a quantitative procedure of obtaining a look into a firm's
functional efficiency, liquidity, revenues, and profitability by analyzing its
financial records and statements. Ratio analysis is a very important factor
that will help in doing an analysis of the fundamentals of equity.

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:
1. Track company performance
Determining individual financial ratios per period and tracking the change
in their values over time is done to spot trends that may be developing in a
company. For example, an increasing debt-to-asset ratio may indicate that
a company is overburdened with debt and may eventually be facing default
risk.
2. Make comparative judgments regarding company performance
Comparing financial ratios with that of major competitors is done to identify
whether a company is performing better or worse than the industry
average. For example, comparing the return on assets between companies
helps an analyst or investor to determine which company is making the
most efficient use of its assets.

Users of financial ratios include parties external and internal to the

company:
1. External users:
Financial analysts, retail investors, creditors, competitors, tax authorities,
regulatory authorities, and industry observers
2. Internal users:
Management team, employees, and owners

Types of Ratios

• Based on Profitability – Profitability Ratios

1. Gross Profit Margin
2. Operating Profit Margin
3. Net Profit Margin
4. Return on Equity (ROE)
5. Return on Assets (ROA)
6. Return on Capital Employed (ROCE)

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• Based on Solvency – Leverage Ratios

1. Debt to Equity Ratio
2. Debt Ratio
3. Proprietary Ratio or Equity Ratio
4. Interest Coverage Ratio
5. Debt Service Coverage Ratio

• Based on Liquidity – Liquidity Ratios

1. Current Ratio
2. Quick Ratio or Acid test Ratio
3. Cash Ratio or Absolute Liquidity Ratio
4. Net Working Capital Ratio

• Based on Wealth Maximisation/Market Value – Market Value Ratios

1. Book value per share ratio
2. Dividend yield ratio
3. Earnings per share ratio
4. Price-earnings ratio

• Based on Turnover – Efficiency Ratios

1. Asset turnover ratio
2. Inventory turnover ratio
3. Receivables turnover ratio
4. Days sales in inventory ratio

Profitability Ratios

1. Gross Profit Margin

• The gross profit margin ratio helps measure how much profit a
company generates from its sales of goods and services after
deducting direct costs or the cost of goods sold.
• Also, a higher gross profit is a positive indication that the
company can cover operating expenses, fixed costs,
depreciation, etc., and generate net income for the company.
• In contrast, a low gross profit margin reflects poorly on the
company, indicating high selling price, low sales, high costs,
severe market competition etc.

Formula

Gross Profit Margin = Gross Profit / Net Sales

Where,
Gross Profit = Net Sales – Cost of Goods Sold
Net Sales = Total Sales – Discounts – Allowances – Sales
Returns
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2. Operating Profit Margin

• Operating Profit Margin helps measure the company’s ability to

maintain operating expenses to generate profit before interest
expense and tax deduction.
• In other words, the revenue that remains after costs is deducted
from net sales. A higher ratio indicates that the company is well
equipped to pay its fixed costs, interest obligations, handle
economic slowdowns and also offer lower prices than its
competitors at lower margins.
• Moreover, the company management most frequently uses this
to improve profitability by managing its costs.

Formula

Operating Profit Margin Ratio = Operating Profit / Net Sales

Where,
Operating Profit = Gross Profit – Operating Expenses – Depreciation
and Amortisation
Net Sales = Total Sales – Discounts – Allowances – Sales Returns

3. Net Profit Margin

• The net profit margin measures the company’s overall

profitability from its sales after deducting all direct and indirect
expenses.
• Also, it is the percentage of revenue that remains after
deducting all expenses, interest and taxes. A higher net profit
indicates that the company is operating well while managing its
costs and pricing of goods and services.
• However, one drawback of using this ratio is that it includes
one-time expenses and gains, making it challenging to compare
performance with its competitors.

Formula

Net Profit Margin Ratio = Net Income / Net Sales

Where,
Net Income = Gross Profit – All Expenses – Interest – Taxes
Net Sales = Total Sales – Discounts – Allowances – Sales
Returns

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4. Return on Equity (ROE)

• ROE measures how well a company can use its shareholders’
money to generate profits.
• Also, it indicates the returns on the sum of money the investors
have invested in the company.
• Furthermore, ROE is usually watched by investors and
analysts.
• Moreover, a higher ROE ratio can be one of the reasons to buy
a company’s stock.
• Companies with a high return on equity can generate cash
internally, and thus they will be less dependent on debt
financing.

Formula

Return on Equity = Net Profit after Taxes / Shareholder’s Equity x 100

Where,
Shareholder’s Equity = Equity Share Capital

5. Return on Assets (ROA)

• Return on Assets (ROA) measures how well a company uses
its assets to generate profits.
• In other words, it focuses on how much profit it generates on
every rupee invested.
• Also, it measures the asset intensity of the company.
• Thus, a lower ROA indicates a more asset-intensive company.
• On the contrary, a higher ROA indicates more profitability
against the company’s number of assets to operate.
• Moreover, companies with higher asset intensity must invest a
significant amount in machinery and equipment to generate
income. For example – telecommunication, car manufacturers,
railroads, etc.

Formula

Return on Assets = Net Profit after Taxes / Total Assets x 100

Where,
Total assets = All the assets on the balance sheet

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6. Return on Capital Employed (ROCE)

• Return on Capital Employed (ROCE) measures the company’s
overall return against the overall investment of both
shareholders and bondholders.
• This ratio is very similar to ROE, but it is more comprehensive
as it includes the returns generated from bondholders capital
investments.

Formula

Return on Capital Employed (ROCE) = EBIT / Capital Employed

Where,
EBIT (Earnings Before Interest & Taxes) = Net Profit Before
Interest and Taxes
Capital Employed = Total Assets – Current Liabilities

Let us understand the calculation of profitability ratios with the

following example.
Company ABC ltd manufactures customised skates where the total
equity capital is Rs 12 crores. At the end of the financial year, the
total assets are Rs 45 lakhs and also current liabilities is Rs 8 lakhs,
and the income statement looks like below –

Particulars Amount (Rs.)

Total Sales 500,000
Cost of Goods Sold 130,000
Gross Profit 370,000
Salary Expense 10,000
Operating Expenses 170,000
Interest 10,000
Depreciation 25000
Taxes 4000
Net Profit 151,000

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Leverage Ratios
Leverage ratios measure the amount of capital that comes from debt. In other
words, leverage financial ratios are used to evaluate a company’s debt levels.

1. Debt to equity ratio

• Debt to equity is one of the most used debt solvency ratios.

• It is also represented as D/E ratio.
• Debt to equity ratio is calculated by dividing a company’s total liabilities
with the shareholder’s equity.
• These values are obtained from the balance sheet of the company’s
financial statements.
• It is an important metric which is used to evaluate a company’s
financial leverage.
• This ratio helps understand if the shareholder’s equity has the ability
to cover all the debts in case business is experiencing a rough time.
• A high debt-to-equity ratio is associated with a higher risk for the
business as it indicates that the company is using debt for fuelling its
growth. It also indicates lower solvency of the business.

It is represented as

Debt to equity ratio = Long term debt / shareholder’s funds

Or
Debt to equity ratio = total liabilities / shareholders’ equity

2. Debt Ratio

• Debt ratio is a financial ratio that is used in measuring a company’s

financial leverage.
• It is calculated by taking the total liabilities and dividing it by total
capital. If the debt ratio is higher, it represents the company is riskier.
• The long-term debts include bank loans, bonds payable, notes payable
etc.
• Low debt to capital ratio is indicative of a business that is stable while
higher ratio casts doubt about a firm’s long-term stability.
• Trading on equity is possible with a higher ratio of debt to capital which
helps generate more income for the shareholders of the company.

Debt ratio is represented as

Debt Ratio = Long Term Debt / Capital or Debt Ratio

= Long Term Debt / Net Assets

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3. Proprietary Ratio or Equity Ratio

• Proprietary ratios are also known as equity ratio. It establishes a
relationship between the proprietor’s funds and the net assets or
capital.
It is expressed as

Equity Ratio = Shareholder’s funds / Capital

or
Shareholder’s funds / Total Assets

4. Interest Coverage Ratio

• The interest coverage ratio is used to determine whether the company
is able to pay interest on the outstanding debt obligations.
• It is calculated by dividing company’s EBIT (Earnings before interest
and taxes) with the interest payment due on debts for the accounting
period.
• A higher coverage ratio is better for the solvency of the business while
a lower coverage ratio indicates debt burden on the business.

It is represented as

Interest coverage ratio = EBIT / interest on long term debt

Where EBIT = Earnings before interest and taxes or Net Profit before
interest and tax.

5. Debt Service Coverage Ratio

• The debt service coverage ratio reveals how easily a company can pay
its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Let us assume a company with the following financials for the current
year. Then, use the calculation of leverage ratios for the same.
Shareholder Equity 19,80,200 Total Assets 30,01,100
Total Capital Employed 21,97,600 Total Debt 2,17,400
Instalment amount 36,400 Interest 2,500
EBIT 4,93,200
Preference Share Capital + Debenture + Long Term Loan 1,32,100
Equity share capital + Reserve and Surplus 49,100
Earnings Available for debt service 4,93,200

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Liquidity Ratios
Liquid funds help a business in meeting its short-term expenses
commitments. Liquidity can be defined as an organization’s ability to
meet an expense or settle a liability towards its stakeholders, as and
when it becomes due. It is a parameter that gives a picture of the
solvency of the firm.
To measure the liquidity, we need to calculate the liquidity ratios. These
ratios give a short-term answer as the creditors are interested in the
current liquidity position of the entity. If the organization is not in a
position to meet its short-term commitments, it has an adverse effect
on its credit rating and credibility. If the organization is not able to
honor its financial commitments, it can result in its bankruptcy or
closure. The liquidity of the organization must neither be insufficient
nor should it be excessive.

Types of Liquidity Ratio

• Current Ratio
• Quick Ratio or Acid test Ratio
• Cash Ratio or Absolute Liquidity Ratio
• Net Working Capital Ratio

Let’s look at these ratios in detail.

Current Ratio
One of the most common ratios for measuring the short-term liquidity
of the firm is the current ratio. This ratio is also called the working
capital ratio. It measures whether the current assets of the firm are
enough to pay the current liabilities or debts of the firm. This ratio keeps
a margin of safety for any potential losses that might occur during the
realization of the current assets. It can be calculated as the ratio
between the Current Assets and Current Liabilities.
The ideal current ratio is 2:1 but it also depends on the characteristics
of the current assets and current liabilities along with the nature of the
business of the firm. Let’s see the heads that are included under current
assets and current liabilities.

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Current Assets
• Stock
• Sundry Debtors
• Cash/ Bank Balances
• Bills receivable
• Accruals
• Short term loans given
• Short term Securities

Current Liabilities
• Creditors
• Outstanding Expenses
• Short Term Loans taken
• Bank Overdrafts
• Provision for Taxation
• Proposed Dividend

Current Ratio Formula

Current Ratio = Current Assets / Current Liabilities
Where,
• Current Assets = Sundry Debtors + Inventories + Cash-at-Bank +
Cash-in-hand + Receivables + Loans and Advances + Advance Tax
+ Disposable Investments
• Current Liabilities = Creditors + Short-term Loans + Bank
Overdraft + Cash Credit + Outstanding expenses + Dividend
payable + Provision for Taxation

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Quick Ratio/ Acid-Test Ratio

Quick Ratio is also known as Acid-test Ratio. It is a measure of the
liquidity calculated on the basis of the relationship between Quick
Assets and Current Liabilities. It is used to calculate if the readily
convertible quick funds are enough to pay the current debts. The ideal
Quick Ratio or Acid-test Ratio is 1:1.

Acid-Test Ratio Formula or Quick Ratio Formula

Quick Ratio= Quick Assets / Current Liabilities
Where,
Quick Assets = Current Assets – Inventories – Prepaid Expenses

Cash Ratio or Absolute Liquidity Ratio

The cash ratio is used to measure the absolute liquidity of the firm. It
calculates whether a firm can use only its cash balances, bank
balances, and marketable securities to pay its current debts. Inventory
and Debtors are not included while calculating this ratio because there
is no guarantee of their realization.
• Cash Ratio Formula
Cash Ratio= Cash and Bank Balances + Marketable Securities +
Current Investments / Current Liabilities
• Net Working Capital Ratio
It is a measure of the cash flow and this ratio should be positive.
This ratio is very important for the bankers as it helps them gauge
if there is a financial crisis in the firm.
• Net Working Capital Ratio Formula
Net Working Capital Ratio= Current Assets – Current Liabilities
(exclude short-term bank borrowing)

Solvency Ratios vs. Liquidity Ratios

Solvency ratios, in contrast to liquidity ratios, assess a company's
capacity to satisfy all of its financial obligations, including long-term
debts. Liquidity focuses on current or short-term financial accounts,
whereas solvency refers to a company's overall capacity to satisfy debt
commitments and maintain its operations.

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To be solvent, a business must have more total assets than total

liabilities; to be liquid, it must have more current assets than current
liabilities. Liquidity ratios provide an early assessment of a company's
solvency, despite the fact that solvency is not directly related to
liquidity.
Divide a company's net income and depreciation by its short- and long-
term obligations to get the solvency ratio. This determines if a
company's net income is sufficient to cover all of its liabilities. A
corporation with a greater solvency ratio is generally thought to be a
better investment.

Solved Example on Liquidity Ratios

1. Calculate the different liquidity ratios from the following particulars

Particulars Amount

Inventory 150,000

Cash 50,000

Sundry Debtors 300,000

Creditors 350,000

Bills Receivable 30,000

Bank Overdraft 30,000

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Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure
how well a company is utilizing its assets and resources. Common efficiency
ratios include:

The asset turnover ratio measures a company’s ability to generate sales from
assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratio measures how many times a company’s

inventory is sold and replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a

company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratio measures the average number of days that
a company holds on to inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock.
Common market value ratios include the following:

The book value per share ratio calculates the per-share value of a company
based on the equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total
common shares outstanding

The dividend yield ratio measures the amount of dividends attributed to

shareholders relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for
each share outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings

per share:

Price-earnings ratio = Share price / Earnings per share

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