Why Financial Ratios Matter in Evaluating Companies
When banks or lenders evaluate a company’s eligibility for a loan, understanding its financial health is crucial. Financial ratio analysis provides a clear, quantifiable insight into how stable, profitable, and efficient a business is. This guide explains key financial ratios with practical examples from a fictional company, XYZ Industries Ltd., to help you grasp these essential concepts easily.
Key Financial Ratios to Know
1. Liquidity Ratios: Can the Company Pay Its Short-Term Debts?
Liquidity ratios measure the company’s ability to meet short-term liabilities without selling long-term assets.
- Where to find data: On the company’s Balance Sheet, look for Current Assets and Current Liabilities.
a) Current Ratio
Formula: Current Assets ÷ Current Liabilities
Example:
- Current Assets: ₹50,00,000
- Current Liabilities: ₹25,00,000
- Calculation: 50,00,000 ÷ 25,00,000 = 2.0
Interpretation:
A current ratio of 2.0 means XYZ Industries holds ₹2 in assets for every ₹1 of short-term debt, indicating strong liquidity.
2. Solvency Ratios: Is the Company Financially Stable Long-Term?
Solvency ratios assess the firm’s ability to repay its long-term obligations.
- Where to find data:
- Total Debt and Total Equity in the Balance Sheet
- EBIT and Interest Expense in the Profit & Loss Account
a) Debt-to-Equity (D/E) Ratio
Formula: Total Debt ÷ Total Equity
Example:
If XYZ Industries has ₹67 lakhs debt and ₹1 crore equity,
D/E Ratio = 67,00,000 ÷ 1,00,00,000 = 0.67
Interpretation:
A D/E ratio of 0.67 indicates moderate use of debt compared to equity—a balanced financial leverage.
b) Debt Service Coverage Ratio (DSCR)
Formula: EBIT ÷ Interest Expense + Principal Repayments (debt service)
Example:
If XYZ Industries earns ₹1.5 crore EBIT and needs ₹1 crore for debt service:
DSCR = 1.5 crore ÷ 1 crore = 1.5
Interpretation:
A DSCR of 1.5 means the company makes 1.5 times the required amount to repay its debts—good loan repayment capacity.
3. Profitability Ratios: How Well Does the Company Generate Profit?
- Where to find data:
- Net Profit from Profit & Loss Account
- Shareholders’ Equity from Balance Sheet
a) Net Profit Margin
Formula: Net Profit ÷ Revenue
Example:
If net profit is ₹20 lakh on ₹100 lakh revenue,
Net Profit Margin = 20,00,000 ÷ 1,00,00,000 = 20%
Interpretation:
XYZ Industries earns ₹20 profit for every ₹100 in sales—a healthy profit margin.
4. Efficiency Ratios: Is the Company Using Its Assets Well?
- Where to find data:
- Revenue, Total Assets, and Inventory in financial statements
a) Asset Turnover Ratio
Formula: Revenue ÷ Total Assets
Example:
XYZ Industries generates ₹60 lakh revenue on ₹1 crore assets:
Asset Turnover = 60,00,000 ÷ 1,00,00,000 = 0.60
Interpretation:
For every ₹1 invested in assets, the company generates ₹0.60 revenue, indicating moderate efficiency.
What Is Net Worth and Why Does It Matter?
Net Worth (Shareholder’s Equity) = Total Assets – Total Liabilities
A higher net worth signals financial strength and lowers the lender’s risk when considering a loan.
Why These Ratios Are Critical in Loan Decisions
- DSCR ensures the company can service debt comfortably.
- D/E Ratio shows how leveraged the company is, influencing risk levels.
- Liquidity Ratios confirm there’s enough short-term cash or assets to meet immediate obligations.
- Profitability Ratios prove the company earns enough to sustain operations and repay loans.
- Net Worth represents financial resilience and the ability to absorb shocks.
Conclusion
Understanding financial ratios empowers both lenders and borrowers to make informed decisions. Whether you’re a business owner seeking credit or a finance professional assessing loans, ratios like DSCR, D/E, and Current Ratio form the backbone of creditworthiness analysis.
Have questions or want to discuss how these ratios relate to your business? Let’s talk!
