Financial Ratios and Analysis

Financial analysis is the analysis of financial statements for decision making purposes. Financial statements serves 

dual purpose: First it’s used to evaluate a company’s performance by internal staffs. Secondly it’s used to evaluate 

the performance of company by outsiders. Internal staffs appraise financial indicators to improve the performance

 of a company whereas external people evaluate financial indicators to decide for investment. If the financial ratios 

are promising, investors will be willing to invest in a company.

For internal control process, the relationship between financial statements(Income Statement, Balance sheet and 

Cash Flow Statement) should be evaluated. Additionally financial ratios should also be evaluated. Together these 

statements serve as an indicator of performance of a company. Also they serve as a benchmark about how

 competitors are performing in the market. If the ratio is higher, then it may mean that the competitors are doing 

better and vice versa. Thus a company gets a chance to improve itself in time.

Financial ratios are the major tool of financial analysis. They help to find out the systematic strength or weakness 

of a company. Thus they are highly important.

Financial ratios can be grouped into following five types:

1. Liquidity ratios

2. Assets management or efficient ratios

3. Debt management ratio or leverage ratios

4. Profitability ratios

5. Market value ratios

We will now deal one by one with these ratios. Firstly we will understand about liquidity ratios.

 

1.  Liquidity ratios: Liquidity ratios are the major part of financial ratio analysis.The purpose of these ratios is to 

find out the solvency position of an organization. This means whether a company is able to pay its short term 

liabilities or not. Being able to pay short term liabilities is crucial for an organization because it helps to build an 

environment of trust in the eyes of investors. This is important for the smooth running of an organization. The major 

liquidity ratios are:

 

 1.a) Current ratio: Current ratio is one of the major financial ratios. It measures the extent to which current 

liabilities is met by current assets. It is calculated by dividing current assets by current liabilities. Current assets are 

liquid and they can generate money in a relatively short period of time. Thus if the ratio of current assets with current 

liabilities is maintained, it becomes easier for payment. The major current assets are cash, Marketable securities, 

saundry debtors, bills receivable and inventory. The major current liabilities are bank overdraft, saundry creditors, 

bills payable and outstanding expenses.

 But one thing we should be careful about! If current ratio is too high, it means a company is inefficient and 

misutilizing its fund in purchasing too much current assets. But if the ratio is too low, then a company can’t fulfill 

its short term obligations. The standard ratio of current assets can vary country-wise but generally a current ratio of

 2:1 is considered best.

Mathematically: Current ratio = Current Assets/ Current Liabilities

1.b) Quick or Liquid or Acid Test Ratio: The purpose of this ratio is to find out the capacity of a company for

 immediate payment of current liabilities.Thus Quick ratio is calculated by deducting inventories from current assets 

and dividing by current liabilities. Inventories are deducted because it can be difficult to liquidate them at their full

 book value, thus rendering them invaluable for payment of current liabilities.

Mathematically, Quick Ratio= (Current assets- Inventories)/ Current liabilities

We can summarize as:

1. The ratio of 1:1 is considered as an ideal ratio for meeting all current liabilities.

2. The ratio greater than 1:1 indicates that a company is in strong position to fulfill its payment 

   liabilities.

3. The ratio less than 1:1 indicates that a company isn’t in position to fulfill its short term obligations.

Quick ratio is important for investors and managers because it provides a more clear view of liquidity position than 

that of Current Ratio.

1.c) Cash Ratio: This ratio gives an idea whether the most liquid assets can cover the current liabilities. These liquid 

assets are cash and marketable securities. Thus its formula is:

Cash ratio= (Cash + Marketable securities)/Current Liabilities

Cash denotes free cash level which can be easily paid to fulfill liabilities. Whereas Marketable securities can easily 

be sold in the stock market to convert them into cash within a short time frame of one year. Thus when the ratio is 

calculated by comparing current liabilities with cash plus marketable securities, it shows the chances of payment of 

current liabilities.  

• A cash ratio of greater than one means that a company is in better position to pay all of its current 

  liabilities.

• A cash ratio less than one means a company may face difficulties in paying its current liabilities.

1.d) Net Working Capital (NWC) to Total Assets Ratio: It is the ratio of net working capital and total assets. Net

 working capital is defined as the difference of current assets and current liabilities.

Thus first it shows how much the current assets is higher than current liabilities. Secondly it shows the ratio of this 

difference with respect to total assets.

Mathematically: NWC to total assets ratio= Net working capital/ Total Assets

                                                                  = (Current Assets-Current Liabilities)/ Total Assets

• Positive value of NWC to total assets ratio indicates that a company is in good position to pay its 

  current liabilities.

• Higher value of NWC to total assets mean that there is high chances that the short term obligation 

  be met

• Lower value of NWC to total assets mean that there is less chance that the short term obligation 

  be met.

• Negative value indicates that there will be difficulty to met the short term obligations.

Together Financial ratios are a major part of financial planning and analysis. They help in performance analysis as 

well as investment analysis. Thus they are used extensively for interpretation purpose.

 

Further Reads

https://usefulfinanceforus.blogspot.com/2025/07/assets-management-ratio.html

https://usefulfinanceforus.blogspot.com/2025/07/debt-management-ratio-analysis.html 

https://usefulfinanceforus.blogspot.com/2025/07/profitability-ratios.html 

 

 

PE Ratio

PE ratio is one of the major ratio which is used to analyze the performance of a company.

It's formula is:

PE ratio= Stock price/ Earning per share

As we can see, the formula of PE ratio summarizes to the excess of stock price in comparison to the earning per share. For example if the price of stock is $100 and earning per share is $50, then the PE ratio is:

PE ratio= Stock price/ EPS = $100/$50 = 2

In analyzing shares, higher PE ratio can mean a company is performing good but it can also mean that the share is overpriced. An investor should analyze the market to understand the value of PE ratio which is good for investment.

Let us take some examples:

• As of the latest data (June 21, 2025), Alphabet Inc. (Google) trades at a trailing P/E of about 16.9×, based on a price of roughly $166.64 and an EPS of $9.15.
• The Trailing Price‑to‑Earnings ratio of Meta is currently about 27.2× as on 21/06/2025.

Analyzing these two stocks clearly shows that it is not necessary that higher PE ratio mean risky shares. It depends on the overall performance of the company.

 

Factors that affect PE ratio

1.     Earning performance of a company: If the earning of a company is high, the PE ratio is less and if the earning of a company is low, the PE ratio is high. Thus we should carefully evaluate the earning of a company while deciding to invest.

 

2.     The price of stocks: An increasing price of stocks increases the PE value and vice versa. This is because as the formula suggests, if the numerator value is higher, the overall value of the ratio is higher.

 

3.     Growth expectations: Companies which are expected to grow in the future have higher PE ratio. This is because the prices of such stocks increases in expectation that their future profits will increase.

 

4.     Risk and Volatility: Higher risky products have lower PE ratio because people are less willing to invest in such stocks.i.e they demand higher return for risk taken. This lowers price and as a result PE ratio decreases.

 

5.     Market Interest rates: If the market interest rate is high, the discounted EPS of a company lowers. This also affects the price of stocks. Thus the PE ratio is low. And if the market rate is lower, the discounted EPS is higher and as a result, the PE ratio is higher. Also the borrowing capacity of investors increase if the market interest rate is low. This increases price of stocks because of higher investing capacity and the PE ratio increases. The same is true for vice versa.

 

6.     Market sentiment and  Investor Behavior: If the market sentiment is bullish, the investor behavior is to increase investment in a stocks. Subsequently the price of stocks increase and thus the PE ratio increases. And if the sentiment in the market is bearish, the price of stocks decrease in anticipation of loses. Thus the PE ratio decreases.

 

7.     Company risk and stability: If the risk of a company is high or cyclical, it decreases PE ratio. This is because investor invest less in anticipation of loses. But in low risk and stable companies, investor estimate profits and the price of stocks is high. Thus the PE ratio is higher.

 

8.     Inflation and Economic conditions: If inflation is high, the purchasing power of investor lowers. As a result, the price of stocks lowers. Also in such economic conditions the profit of companies lowers. Thus PE ratio become lower. The vice versa is true for when the inflation is lower.

 

9.     Debt Levels: If a company operates in higher debt level, then it experiences lower earning per share. This is because the majority of income goes in payment of interest of debt. Thus the price of such stocks also lower because investor anticipate lower returns in terms of dividend and bonus share. Thus PE ratio becomes lower.

 But if the debt level is lower, the EPS becomes higher. The price of such stocks increases because investors can get higher return and thus the PE ratio increases.

 

10.  Dividend Policy: The companies which pay higher dividend may have lower P/E Ratios because they return cash to shareholders instead of reinvesting for growth. Thus their future profits decrease. Thus can also lower their share value. As a result the PE ratio becomes lower.

            But the companies which focus on growth and pay less dividend have higher PE ratios because                  they earn more by reinvesting. Thus the earning per share also increases as well as the price of                    stocks also increase.