Ratio Analysis and Financial Planning

Why a single number is never enough

A firm reporting a net profit of ₹50 lakh tells you almost nothing on its own. Is that a good result? It depends entirely on what it is compared against — the firm's own profit last year, the capital employed to generate it, the sales that produced it, or a competitor earning the same profit on half the capital. Ratio analysis exists precisely because absolute figures from financial statements are not directly comparable across time, across firms of different sizes, or across industries with different capital intensities, and expressing one figure as a ratio of another converts an isolated number into a comparable signal.

This chapter groups ratios by what they measure — liquidity, solvency, profitability, activity or turnover, and market-related — because a ratio is only useful when you know what question it is answering. Financial planning then takes these same statements forward in time, using techniques like the percentage of sales method to forecast how much additional financing a growing firm will need.

Liquidity ratios: can the firm meet its near-term obligations?

Liquidity ratios ask whether a firm can pay what it owes in the near term using what it holds in the near term.

The current ratio, current assets divided by current liabilities, is the broadest liquidity measure. A ratio comfortably above 1 suggests current assets exceed current liabilities, but the conventionally cited benchmark of 2:1 is a rule of thumb, not a universal rule — the appropriate level genuinely varies by industry, since a business with fast-moving, highly liquid inventory needs a lower cushion than one whose inventory turns over slowly.

The quick ratio, also called the acid-test ratio, refines this by excluding inventory and prepaid expenses from current assets before dividing by current liabilities, on the reasoning that inventory is the least liquid current asset — it must first be sold, and then the resulting receivable must be collected, before it becomes cash. A firm can show a healthy current ratio while its quick ratio reveals that most of that apparent liquidity is tied up in inventory that may take time to convert, which is exactly the kind of gap between the two ratios that examiners test.

Solvency ratios: can the firm meet its long-term obligations?

Solvency, sometimes called leverage or capital structure ratios in this context, asks a longer-horizon question: is the firm's capital structure sustainable, and how exposed is it to fixed financial obligations.

The debt-equity ratio, total debt divided by shareholders' equity, measures how much of the firm's financing comes from borrowed funds relative to owned funds. A higher ratio signals higher financial risk, since debt carries a fixed obligation to pay interest and repay principal regardless of the firm's performance, while equity carries no such fixed claim.

The interest coverage ratio, EBIT divided by interest expense, measures how comfortably the firm's operating earnings cover its interest obligation. A ratio of 1 means EBIT exactly covers interest with nothing left over; a ratio below 1 means the firm cannot cover interest from operating earnings at all in that period. This ratio matters more directly than the debt-equity ratio for assessing near-term default risk, because a firm can carry a moderate debt-equity ratio and still face genuine difficulty if a bad year leaves EBIT insufficient to cover the interest actually due.

Profitability ratios: how well is the firm converting activity into profit?

Profitability ratios are typically expressed as a percentage and fall into two families: margin ratios, expressed on sales, and return ratios, expressed on capital or investment.

Gross profit margin, gross profit divided by net sales, shows what proportion of sales revenue remains after covering the direct cost of the goods sold, before operating expenses. Net profit margin, net profit divided by net sales, carries this further down the income statement, after all operating expenses, interest and tax.

Return on capital employed, EBIT divided by capital employed, measures how efficiently the firm generates operating profit from the total capital, debt and equity together, invested in the business, independent of how that capital happens to be split between the two. Return on equity, net profit available to equity shareholders divided by equity shareholders' funds, measures the return specifically to the equity investor, and because it sits after interest has already been deducted, it reflects the effect of financial leverage — a firm using debt profitably, earning more on borrowed funds than the interest cost of that debt, will show a return on equity higher than its return on capital employed, and this gap is precisely how the benefit of financial leverage shows up in the ratios.

Activity or turnover ratios: how efficiently are assets being used?

Turnover ratios measure how efficiently a firm converts its assets into sales, and several of them feed directly into the operating cycle calculation used later in working capital management.

Inventory turnover ratio, cost of goods sold divided by average inventory, indicates how many times inventory is sold and replaced over a period; a low turnover can signal slow-moving or excess inventory. Debtors turnover ratio, credit sales divided by average debtors, and its companion, the average collection period, 365 divided by debtors turnover, together measure how quickly the firm collects cash from its credit customers. Total assets turnover ratio, net sales divided by total assets, measures the overall efficiency with which the firm's full asset base is used to generate sales.

The DuPont framework: decomposing return on equity

The DuPont analysis is the single most examined structural insight in this chapter, because it takes return on equity, a single number, and decomposes it into three multiplicative components that each answer a different question about how that return was achieved:

Return on equity = Net profit margin × Total assets turnover × Equity multiplier

Net profit margin answers how profitable each rupee of sales is. Total assets turnover answers how efficiently assets are used to generate sales. The equity multiplier, total assets divided by equity, answers how much financial leverage the firm employs — a higher multiplier means a larger portion of the asset base is financed by debt rather than equity.

The value of this decomposition is diagnostic: two firms can report an identical return on equity of, say, 15%, yet arrive at it through entirely different combinations — one through high margins on modest turnover with low leverage, the other through thin margins on high turnover amplified by heavy leverage. A firm relying on the third component, leverage, to prop up an otherwise mediocre return on equity is a materially riskier firm than one earning the same return through genuine operating profitability, even though the headline ratio looks identical, and DuPont is precisely the tool that exposes this difference.

Reading ratios together, not in isolation

A recurring theme worth stating explicitly: a single ratio read alone can mislead, and the strongest answers in this chapter compare related ratios to each other rather than reciting each in isolation. A rising current ratio alongside a falling quick ratio signals a build-up of inventory relative to more liquid assets. A rising return on equity alongside a rising equity multiplier, with net profit margin flat, signals that the improvement is coming from leverage rather than operations. A firm's inventory turnover slowing while its current ratio improves is not necessarily a sign of health — it may simply mean unsold stock is piling up and inflating current assets. Ratio analysis rewards this kind of cross-referencing far more than the mechanical computation of each ratio in isolation.

Financial planning and the percentage of sales method

Financial planning translates a firm's growth expectations into a forecast of how much additional financing that growth will require. The most commonly examined technique is the percentage of sales method.

The method rests on a simplifying assumption: many balance sheet items — inventory, debtors, trade creditors, and so on — move roughly in proportion to sales, since a firm selling more typically needs more inventory to support those sales and, if selling on credit, will carry proportionately more debtors, while its trade creditors similarly tend to rise with higher purchasing activity. Items that do not move proportionately with sales — typically fixed assets in the short run, if there is spare capacity, and long-term debt or share capital, which change only through deliberate financing decisions rather than automatically with sales — are held constant in the projection.

The procedure is to express each spontaneously-varying balance sheet item as a percentage of the current year's sales, project the following year's sales, apply the same percentages to the projected sales figure to estimate each item's projected balance, and then compare projected total assets against projected total liabilities plus equity, including the increase in retained earnings the projected profit is expected to generate. The gap between the two sides is the external funds requirement — the additional financing the firm must raise, whether as debt, equity, or some combination, to support the projected level of sales.

This external funds requirement is sensitive to three levers worth stating explicitly, because they are the basis of the questions built around this technique: a higher expected sales growth rate increases the funds required, since more assets are needed to support higher sales; a higher net profit margin decreases the funds required, since more of the growth is self-financed through retained earnings; and a higher dividend payout ratio increases the funds required, since less of that profit is retained, directly echoing the interdependence between the dividend decision and the financing decision introduced in the previous chapter.

Limitations of ratio analysis and financial planning

Ratios are only as reliable as the financial statements they are drawn from, and are vulnerable to differences in accounting policy between firms, to seasonal distortions if a balance sheet date happens to fall at an unusually high or low point in the firm's operating cycle, and to the general limitation that a ratio is a historical, backward-looking figure computed from past statements, applied to judge a firm's likely future performance. The percentage of sales method, similarly, rests on the assumption that historical relationships between sales and each balance sheet item will hold going forward, an assumption that can break down if the firm's operating efficiency, credit terms, or asset intensity is genuinely changing rather than merely scaling up proportionately. Neither tool is therefore a substitute for judgement about whether the underlying assumptions genuinely hold for the specific firm and period being examined.