Accounting Ratios

The full picture

Imagine you get two annual reports: one company has ₹80 lakh in profit, another has ₹20 lakh. Which is doing better? You cannot tell from those numbers alone — you need to know how large each company is, how much debt it carries, and how efficiently it uses its resources. That is exactly what accounting ratios do. A ratio is simply one financial figure divided by another, expressed as a proportion, percentage, or times figure. Ratios convert raw rupee amounts into comparable, meaningful measures that tell a story about a business.

There are four families of ratios, each answering a different question. Liquidity ratios ask: can the company pay its short-term dues comfortably? Solvency ratios ask: is the company safe from long-term debt risk? Activity ratios ask: is the company using its assets productively to generate sales? Profitability ratios ask: how much profit is the company earning on its sales, assets, and owners' capital? Think of these four families as four check-up readings — like a doctor checking your temperature, blood pressure, pulse, and oxygen level. One reading alone is not enough; you need all four together for a complete diagnosis.

Liquidity ratios focus on the next twelve months. The Current Ratio = Current Assets ÷ Current Liabilities. It tells you how many rupees of short-term assets back every rupee of short-term debt. A ratio of 2:1 is generally considered healthy — you have ₹2 to cover every ₹1 owed. The Quick Ratio (or Acid-Test Ratio) = (Current Assets − Inventories − Prepaid Expenses) ÷ Current Liabilities. It is stricter because it removes inventory, which may not convert to cash quickly. If a kirana shop's stock of unsold goods cannot be sold fast enough to pay a supplier tomorrow, only the quick ratio reveals that risk. A quick ratio below 1:1 is a warning sign.

Solvency ratios look at long-term financial stability. The Debt-to-Equity Ratio = Long-Term Debt ÷ Shareholders' Funds. A ratio of 2:1 means the company owes creditors twice what the owners have put in — higher leverage means higher risk if profits fall. The Interest Coverage Ratio = Net Profit Before Interest and Tax ÷ Interest Expense. It shows how many times over the company can pay its annual interest. If a company earns ₹50 lakh before interest and pays ₹10 lakh as interest, coverage is 5 times — comfortable. If coverage drops to 1.5 times, even a small dip in earnings could mean the company cannot service its debt.

Activity ratios measure how productively the company turns its assets into sales. Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory — it shows how many times the company sold and replaced its stock during the year. A higher number means faster-moving goods. Trade Receivables Turnover Ratio = Net Credit Sales ÷ Average Trade Receivables — a higher figure means customers are paying sooner. Asset Turnover Ratio = Net Sales ÷ Average Total Assets — it tells you how many rupees of revenue every rupee of assets generates. A textile company generating ₹3 of sales for every ₹1 of assets is using its factory and machines far more efficiently than a competitor generating only ₹1.50.

Profitability ratios show how much of each rupee earned ends up as profit. Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100 — it captures what is left after cost of goods sold, before operating expenses. Operating Profit Ratio = (Operating Profit ÷ Net Sales) × 100 — it shows efficiency after all day-to-day costs. Net Profit Ratio = (Net Profit After Tax ÷ Net Sales) × 100 — the bottom line percentage. Return on Investment (ROI) or Return on Capital Employed = Net Profit Before Interest and Tax ÷ Capital Employed — it tells shareholders and lenders how productively the total capital in the business is being used. These ratios let you compare a startup with a 3% net margin against a well-run company with 12%, and understand which is actually more rewarding for owners once you factor in turnover and leverage.

One important caution: no single ratio tells the whole truth, and a ratio only becomes meaningful when compared against something — the company's own past performance, an industry benchmark, or a competitor. A current ratio of 1.2:1 could be dangerously low for a manufacturing firm with slow-moving inventory but perfectly fine for a supermarket chain that collects cash instantly. Always ask: compared to what? Also, ratios are based on historical data from financial statements — they are a rear-view mirror, not a crystal ball. Use them as a starting point for analysis, not the final answer.

An Indian example

Priya's father owns a small garment manufacturing unit in Tiruppur, Tamil Nadu. In March, he approaches his bank for a ₹40 lakh working capital loan. The bank's credit officer pulls out two years of his financial statements and immediately computes four ratios. The current ratio has improved from 1.3:1 to 1.8:1 — a positive sign. The debt-to-equity ratio stands at 0.8:1, meaning the business is not over-borrowed. The inventory turnover ratio is 6 times a year, showing that stock moves quickly in the seasonal garment business. The net profit ratio is 8%, which is healthy for this industry. The credit officer compares these numbers against the bank's internal benchmark for textile SMEs and approves the loan. Had the current ratio been below 1:1 or the debt-equity above 3:1, the application would have been flagged for review. Priya watches this process and realises that every number on her father's balance sheet carries a message — and ratio analysis is the language that bankers, investors, and business owners all speak.

Key concepts covered

• Liquidity ratios
• Solvency ratios
• Activity ratios
• Profitability ratios

Common misconceptions to watch for

• A higher current ratio is always safer. Not true — a current ratio of 5:1 or 6:1 often means the company is hoarding cash or holding too much slow-moving inventory instead of investing that capital productively; the ideal range for most industries is 1.5:1 to 2:1, and anything far above it can signal poor capital management.
• Return on Equity (ROE) and Net Profit Ratio mean the same thing because both involve profit. They do not — Net Profit Ratio is profit as a percentage of sales (how much you earn per rupee sold), while ROE is profit as a percentage of shareholders' funds (how much you earn per rupee the owners invested); a company with a thin 4% net margin can still have a strong 20% ROE if it turns over its assets rapidly and uses moderate leverage.
• You only need liquidity ratios to judge if a company is healthy. A company can have a comfortable current ratio of 2:1 yet still be in serious trouble — high long-term debt (poor solvency), slow-moving inventory (poor activity), and zero profit (poor profitability) would all go undetected if you stopped at liquidity; all four ratio families must be read together, just like a doctor needs all vital signs, not just your temperature.