Ratio Analysis — Current, Quick, Debt-Equity, ROE & Turnover Ratios

Ratio Analysis is one of the most important tools for financial statement analysis and a heavily tested topic in the JAIIB AFM paper. Bankers use ratio analysis extensively during credit appraisal to assess a borrower's liquidity, solvency, profitability, and operational efficiency. Understanding key ratios — their formulas, ideal values, and interpretation — is essential for every banking professional. This comprehensive guide covers all major ratios with formulas, interpretation, and relevance to banking decisions.

Categories of Financial Ratios

Financial ratios are broadly classified into four categories: (1) Liquidity Ratios — measure ability to meet short-term obligations (Current Ratio, Quick Ratio); (2) Solvency/Leverage Ratios — measure long-term financial stability (Debt-Equity Ratio, Interest Coverage Ratio); (3) Profitability Ratios — measure earning capacity (ROE, Net Profit Margin, ROCE); (4) Activity/Turnover Ratios — measure operational efficiency (Inventory Turnover, Debtors Turnover, Fixed Asset Turnover).

Key Ratios — Formulas & Interpretation

Liquidity Ratios Explained

The Current Ratio measures whether a company has enough current assets to cover its short-term liabilities. A ratio below 1 indicates potential difficulty in meeting obligations. For bank lending, a current ratio of 1.33:1 is generally considered the minimum benchmark. The Quick Ratio (Acid Test) is more stringent — it excludes inventory and prepaid expenses (which may not be quickly convertible to cash) from current assets. A quick ratio of 1:1 means the firm can meet all current liabilities from its most liquid assets alone.

Solvency & Leverage Ratios

The Debt-Equity Ratio indicates the proportion of borrowed funds versus owners' funds. A higher ratio means more leverage and higher financial risk. Banks typically prefer D/E of 2:1 or lower for term loan sanction. The Debt Service Coverage Ratio (DSCR) is another crucial ratio: DSCR = (Net Profit + Depreciation + Interest on TL) / (Interest on TL + TL Instalment). Banks require a minimum DSCR of 1.5:1 to 2:1 for project viability.

Profitability Ratios

ROE measures the return generated on shareholders' equity investment. A consistently high ROE indicates efficient use of equity capital. Net Profit Margin (Net Profit/Sales × 100) shows what percentage of sales translates into profit after all expenses. Gross Profit Margin (Gross Profit/Sales × 100) shows efficiency in production/trading operations. Return on Capital Employed (ROCE = EBIT / Capital Employed × 100) measures efficiency of total capital deployed irrespective of the financing mix.

Activity/Turnover Ratios

Inventory Turnover Ratio indicates how many times inventory is sold and replaced during a period. A higher ratio means efficient inventory management. Inventory Holding Period = 365 / Inventory Turnover (days). Debtors Turnover Ratio measures how efficiently credit sales are collected. Average Collection Period = 365 / Debtors Turnover (days). For bankers, a high collection period is a red flag indicating potential cash flow issues or poor debtor quality.

DuPont Analysis

DuPont Analysis breaks ROE into three components to identify the drivers of return: ROE = Net Profit Margin × Asset Turnover × Equity Multiplier = (Net Profit/Sales) × (Sales/Total Assets) × (Total Assets/Equity). This decomposition helps bankers understand whether high ROE comes from operational efficiency, efficient asset use, or high leverage (which increases risk).

Key Points for JAIIB Exam

Sample MCQs for JAIIB AFM