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Introduction

[fusion_dropcap class="fusion-content-tb-dropcap"]U[/fusion_dropcap]nderstanding ratio analysis is like having a magnifying glass to examine the health of a business. Whether you’re a student, a budding entrepreneur, or someone brushing up on finance, knowing key financial ratio formulas helps you interpret numbers better—and make smarter decisions.

In this blog post, we’ll cover all important ratio formulas—classified under liquidity, solvency, profitability, activity, and market ratios. Plus, we’ll simplify the concepts to make them easy and practical.

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📘 What is Ratio Analysis?

Ratio analysis involves calculating and interpreting financial ratios from a company’s financial statements. These ratios offer insights into a business’s performance, efficiency, liquidity, profitability, and solvency.

Let’s break them down one by one.

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1. Liquidity Ratios – Can the business pay its short-term dues?

These ratios assess whether the company can meet short-term obligations using its current assets.

🔹 Current Ratio

Formula:
Current Ratio = Current Assets / Current Liabilities

Use: Indicates the company’s ability to cover short-term liabilities with short-term assets. A ratio above 1 is generally considered healthy.

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🔹 Quick Ratio (Acid-Test Ratio)

Formula:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Use: A more stringent test than the current ratio; excludes inventory which may not be quickly liquidated.

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🔹 Cash Ratio

Formula:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Use: Shows the firm’s ability to pay off current liabilities using only cash or equivalents.

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2. Solvency Ratios – Is the business financially stable long-term?

These ratios analyze a company’s ability to meet its long-term financial obligations.

🔹 Debt to Equity Ratio

Formula:
Debt to Equity Ratio = Total Debt / Shareholders' Equity

Use: Measures the relative proportion of shareholders’ equity and debt used to finance the company.

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🔹 Interest Coverage Ratio

Formula:
Interest Coverage Ratio = EBIT / Interest Expenses

Use: Shows how comfortably a company can pay interest on outstanding debt.

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🔹 Debt Ratio

Formula:
Debt Ratio = Total Liabilities / Total Assets

Use: Indicates the percentage of assets financed through debt.

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3. Profitability Ratios – Is the business making enough profit?

These ratios evaluate how well a company generates profit relative to its revenue, assets, or equity.

🔹 Gross Profit Ratio

Formula:
Gross Profit Ratio = (Gross Profit / Net Sales) × 100

Use: Reflects the efficiency of production or service delivery.

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🔹 Net Profit Ratio

Formula:
Net Profit Ratio = (Net Profit / Net Sales) × 100

Use: Shows how much profit remains after all expenses, taxes, and costs.

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🔹 Operating Profit Ratio

Formula:
Operating Profit Ratio = (Operating Profit / Net Sales) × 100

Use: Focuses purely on core business performance, excluding non-operating income or expenses.

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🔹 Return on Capital Employed (ROCE)

Formula:
ROCE = EBIT / Capital Employed × 100

Use: Measures how efficiently capital is used to generate profits.

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🔹 Return on Equity (ROE)

Formula:
ROE = Net Profit / Shareholders' Equity × 100

Use: Shows how much profit is generated per rupee of equity invested.

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🔹 Return on Assets (ROA)

Formula:
ROA = Net Profit / Total Assets × 100

Use: Indicates how effectively assets are used to produce profits.

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4. Activity Ratios – How efficiently are resources being used?

These ratios measure how well a company uses its assets to generate revenue.

🔹 Inventory Turnover Ratio

Formula:
Inventory Turnover = Cost of Goods Sold / Average Inventory

Use: Reflects how many times inventory is sold or used in a period.

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🔹 Debtors Turnover Ratio

Formula:
Debtors Turnover = Net Credit Sales / Average Accounts Receivable

Use: Shows how efficiently receivables are collected.

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🔹 Creditors Turnover Ratio

Formula:
Creditors Turnover = Net Credit Purchases / Average Accounts Payable

Use: Indicates how quickly the business pays its suppliers.

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🔹 Working Capital Turnover Ratio

Formula:
Working Capital Turnover = Net Sales / Working Capital

Use: Measures how effectively the working capital is utilized to generate sales.

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🔹 Total Asset Turnover Ratio

Formula:
Total Asset Turnover = Net Sales / Total Assets

Use: Shows how efficiently total assets are used to generate revenue.

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5. Market Valuation Ratios – What do investors think?

These ratios are crucial for investors who want to assess the value of a company’s shares.

🔹 Earnings Per Share (EPS)

Formula:
EPS = (Net Profit - Preference Dividend) / No. of Equity Shares

Use: Tells how much profit is attributable to each share.

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🔹 Price to Earnings Ratio (P/E)

Formula:
P/E Ratio = Market Price per Share / Earnings per Share

Use: Indicates investor expectations; higher P/E usually means higher growth expectations.

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🔹 Dividend Yield

Formula:
Dividend Yield = (Dividend per Share / Market Price per Share) × 100

Use: Shows the return on investment from dividends.

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🔹 Book Value per Share

Formula:
Book Value per Share = (Shareholders' Equity - Preference Equity) / No. of Equity Shares

Use: Reflects the per-share value based on the company’s books.

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✏️ Why Do Ratio Formulas Matter?

Knowing these formulas is one thing. Understanding when and why to use them is key. Here’s why they matter:

• 📊 Decision-making: Ratios guide investment, budgeting, and strategic moves.
• 🔍 Financial analysis: Helps stakeholders evaluate business health.
• 💼 Creditworthiness: Banks and investors rely on ratios before lending.
• 🎓 Academic value: Crucial for students studying commerce, accounting, or finance.

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📌 Bonus: How to Remember These Ratios Easily

• Group them by function (Liquidity, Profitability, etc.)
• Use mnemonics (e.g., “LPSD” for Liquidity, Profitability, Solvency, and Debt)
• Practice with real company reports—see how they’re applied.

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Conclusion

There you have it—all the essential ratio formulas you’ll ever need, broken down simply and clearly. Whether you’re decoding your balance sheet or prepping for exams, these ratios are the building blocks of financial literacy.

“Numbers don’t lie, but understanding them reveals the truth.”

Bookmark this guide, share it with your peers, and revisit it whenever you need a quick refresher on financial ratios.

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