Why Ratio Analysis?

Ratio analysis transforms raw financial numbers into meaningful insights. For financial modeling, ratios help you:

  • Compare companies of different sizes (TCS vs. smaller IT firms)
  • Track performance over time (trend analysis)
  • Benchmark against industry standards
  • Build model assumptions for projections
  • Identify red flags before investing
For Financial Modeling

Ratios form the foundation of model assumptions. Historical ratios (margins, turnover, leverage) are analyzed to project future financial statements.

1

Profitability Ratios

Measure how efficiently a company generates profits from its operations, assets, and equity.

Profitability Ratios

Essential for valuation and earnings quality assessment in financial models

A. Margin Ratios

Gross Profit Margin

GPM = (Revenue - COGS) / Revenue × 100

Measures production/service efficiency. Higher = better cost management.

IT Industry: 25-35%
TCS Example (FY24)
GPM = (₹2,30,000 - ₹1,54,000) / ₹2,30,000 × 100
Gross Margin = 33.0%

EBITDA Margin

EBITDA Margin = EBITDA / Revenue × 100

Operating profitability before non-cash expenses. Key valuation metric.

IT Industry: 20-28%
TCS Example (FY24)
EBITDA Margin = ₹56,500 / ₹2,30,000 × 100
EBITDA Margin = 24.6%

Net Profit Margin

NPM = Net Profit / Revenue × 100

Bottom-line profitability. What percentage of revenue becomes profit.

IT Industry: 12-18%
TCS Example (FY24)
NPM = ₹33,000 / ₹2,30,000 × 100
Net Profit Margin = 14.3%

B. Return Ratios

Return on Equity (ROE)

ROE = Net Profit / Shareholders' Equity × 100

Return generated on shareholders' capital. Most important profitability metric for investors.

Good: >15% | Excellent: >20%
TCS Example (FY24)
ROE = ₹33,000 / ₹1,32,000 × 100
ROE = 25.0%

Return on Capital Employed (ROCE)

ROCE = EBIT / (Total Assets - Current Liabilities) × 100

Return on all capital invested (equity + debt). Better for comparing leveraged companies.

Good: >12% | Excellent: >18%
TCS Example (FY24)
ROCE = ₹44,500 / (₹1,76,690 - ₹32,456) × 100
ROCE = 30.9%

Return on Assets (ROA)

ROA = Net Profit / Total Assets × 100

How efficiently assets generate profits. Asset-light companies (IT) have higher ROA.

IT Industry: 15-25%
TCS Example (FY24)
ROA = ₹33,000 / ₹1,76,690 × 100
ROA = 18.7%
Modeling Tip: Margin Projections

When building financial models, analyze 5-year margin trends. For TCS: EBITDA margins stable at 24-26%. Project margins based on management guidance and competitive pressures. Employee cost as % of revenue is the key driver for IT companies.

Profitability Ratios Quiz
Question 1 of 5
1. If TCS has Revenue of ₹2,30,000 Cr and Net Profit of ₹33,000 Cr, what is the Net Profit Margin?
A12.5%
B14.3%
C16.8%
D18.2%
2

Leverage Ratios

Assess financial risk by measuring the company's debt levels and ability to service debt obligations.

Leverage / Solvency Ratios

Critical for assessing bankruptcy risk and cost of capital in valuation

Debt-to-Equity Ratio

D/E = Total Debt / Shareholders' Equity

Measures financial leverage. Higher ratio = higher financial risk but potentially higher returns.

IT: <0.3 | Manufacturing: 0.5-1.0
TCS Example (FY24)
D/E = ₹2,845 / ₹1,32,000
D/E = 0.02 (Virtually debt-free!)

Interest Coverage Ratio

ICR = EBIT / Interest Expense

Ability to pay interest from operating profits. Below 1.5 indicates distress.

Safe: >3 | Comfortable: >5
TCS Example (FY24)
ICR = ₹44,500 / ₹500
ICR = 89x (Excellent!)

Debt-to-EBITDA

Debt/EBITDA = Total Debt / EBITDA

Years needed to repay debt using EBITDA. Key metric for credit rating agencies.

Safe: <3 | Risky: >4
TCS Example (FY24)
Debt/EBITDA = ₹2,845 / ₹56,500
Debt/EBITDA = 0.05x

Debt-to-Assets Ratio

Debt/Assets = Total Debt / Total Assets

Percentage of assets financed by debt. Lower = more financial stability.

Conservative: <0.3
TCS Example (FY24)
Debt/Assets = ₹2,845 / ₹1,76,690
Debt/Assets = 1.6%

Fixed Charge Coverage

FCC = (EBITDA - Capex) / (Interest + Principal)

Ability to meet all fixed obligations. More comprehensive than Interest Coverage.

Healthy: >1.5
TCS Example (FY24)
FCC = (₹56,500 - ₹8,500) / (₹500 + ₹500)
FCC = 48x
Red Flags in Leverage

Watch out for: Rising D/E over years, ICR falling below 2, Debt/EBITDA >4, High promoter pledging (>25% of holdings). These indicate potential financial distress.

Modeling Tip: Cost of Debt

For WACC calculation, use effective interest rate from annual report: Interest Expense / Average Debt. TCS's cost of debt is ~6-7%. Low leverage companies like TCS have lower WACC due to minimal debt component.

Leverage Ratios Quiz
Question 1 of 5
1. A company has Total Debt of ₹10,000 Cr and Shareholders' Equity of ₹40,000 Cr. What is its Debt-to-Equity ratio?
A0.15
B0.25
C0.40
D4.00
3

Operating / Efficiency Ratios

Measure how efficiently a company manages its operations, working capital, and assets.

Operating / Efficiency Ratios

Key drivers of cash flow and working capital requirements in models

A. Working Capital Ratios

Days Sales Outstanding (DSO)

DSO = (Trade Receivables / Revenue) × 365

Average days to collect payment from customers. Lower = better cash collection.

IT Industry: 60-90 days
TCS Example (FY24)
DSO = (₹28,567 / ₹2,30,000) × 365
DSO = 45 days (Excellent!)

Days Inventory Outstanding (DIO)

DIO = (Inventory / COGS) × 365

Days to sell inventory. Low for IT companies (service-based), high for manufacturing.

IT: <10 | Manufacturing: 30-60
TCS Example (FY24)
DIO = (₹234 / ₹1,54,000) × 365
DIO = 0.6 days

Days Payable Outstanding (DPO)

DPO = (Trade Payables / COGS) × 365

Days to pay suppliers. Higher = better (using supplier credit as free financing).

IT Industry: 30-60 days
TCS Example (FY24)
DPO = (₹8,234 / ₹1,54,000) × 365
DPO = 20 days

Cash Conversion Cycle (CCC)

CCC = DSO + DIO - DPO
Number of days to convert operations into cash
TCS Cash Conversion Cycle
CCC = 45 + 0.6 - 20 = 25.6 days

TCS collects cash in ~26 days after paying suppliers - excellent working capital efficiency!

For Modeling

CCC is critical for projecting working capital in financial models. Use historical DSO, DIO, DPO trends. Negative CCC (like Amazon) means suppliers fund operations!

B. Asset Turnover Ratios

Asset Turnover

Asset Turnover = Revenue / Total Assets

Revenue generated per rupee of assets. Higher = more efficient asset utilization.

IT: 1.0-1.5 | Retail: 2-3
TCS Example (FY24)
Asset Turnover = ₹2,30,000 / ₹1,76,690
Asset Turnover = 1.30x

Fixed Asset Turnover

FAT = Revenue / Net Fixed Assets

Revenue per rupee of fixed assets. IT companies have high FAT (asset-light model).

IT: 5-10 | Manufacturing: 1-3
TCS Example (FY24)
FAT = ₹2,30,000 / ₹32,456
Fixed Asset Turnover = 7.1x

Revenue per Employee

Rev/Employee = Revenue / Total Employees

Productivity measure for service companies. Higher = better employee productivity.

IT Industry: ₹35-50 Lakhs
TCS Example (FY24)
Rev/Employee = ₹2,30,000 Cr / 6,00,000
Revenue per Employee = ₹38.3 Lakhs
Modeling Tip: Working Capital Projection

In financial models, project Trade Receivables = (DSO/365) × Revenue, Inventory = (DIO/365) × COGS, Trade Payables = (DPO/365) × COGS. Use historical averages or management guidance for DSO/DIO/DPO assumptions.

Operating Ratios Quiz
Question 1 of 5
1. If Trade Receivables are ₹30,000 Cr and Revenue is ₹2,00,000 Cr, what is the DSO?
A45 days
B55 days
C60 days
D75 days
4

Valuation Ratios

Determine if a stock is fairly valued, overvalued, or undervalued relative to peers and market.

Valuation / Market Ratios

Essential for investment decisions and relative valuation in models

Price-to-Earnings (P/E)

P/E = Market Price / Earnings Per Share

Price paid per rupee of earnings. Higher P/E = growth expectations or overvaluation.

IT Industry: 20-35x
TCS Example
P/E = ₹3,500 / ₹89 (EPS)
P/E = 39.3x

Price-to-Book (P/B)

P/B = Market Price / Book Value Per Share

Market value vs. accounting book value. P/B > 3 indicates intangible value/growth.

IT Industry: 4-10x
TCS Example
P/B = ₹3,500 / ₹357 (BVPS)
P/B = 9.8x

EV/EBITDA

EV/EBITDA = Enterprise Value / EBITDA

Capital-structure neutral valuation. Better for comparing companies with different debt levels.

IT Industry: 12-20x
TCS Example
EV/EBITDA = ₹13,00,000 Cr / ₹56,500 Cr
EV/EBITDA = 23.0x

Dividend Yield

Div Yield = (DPS / Market Price) × 100

Annual dividend as % of price. Higher yield = more income-focused investment.

IT Industry: 1-3%
TCS Example
Div Yield = (₹120 / ₹3,500) × 100
Dividend Yield = 3.4%

PEG Ratio

PEG = P/E Ratio / Earnings Growth Rate

P/E adjusted for growth. PEG < 1 = undervalued, PEG > 2 = overvalued.

Fair Value: 1.0-1.5
TCS Example
PEG = 39.3 / 8 (growth %)
PEG = 4.9 (Expensive)

Price-to-Sales (P/S)

P/S = Market Cap / Revenue

Useful for valuing unprofitable companies. Lower = cheaper relative to sales.

IT Industry: 4-8x
TCS Example
P/S = ₹13,00,000 Cr / ₹2,30,000 Cr
P/S = 5.7x

Indian IT Sector: Valuation Comparison (FY24)

Company P/E P/B EV/EBITDA ROE Div Yield Verdict
TCS 39.3 9.8 23.0 25.0% 3.4% Premium
Infosys 24.5 6.8 15.2 24.2% 2.8% Fair
Wipro 21.3 3.5 12.8 16.5% 2.1% Attractive
HCL Tech 22.8 5.2 13.5 22.1% 3.8% Value
Tech Mahindra 18.5 3.8 10.2 18.2% 2.5% Value
Analysis Insight

TCS trades at a premium valuation due to consistent performance, strong cash flows, and high dividend payouts. For value investing, HCL Tech and Tech Mahindra offer better valuations with decent ROE.

Modeling Tip: Terminal Value Multiples

For DCF valuation, use exit multiples based on industry averages. IT companies typically use EV/EBITDA of 12-15x as terminal multiple. P/E is more volatile and less preferred for terminal value.

Valuation Ratios Quiz
Question 1 of 5
1. If Market Price is ₹3,500 and EPS is ₹89, what is the P/E ratio?
A29.3x
B35.4x
C39.3x
D45.2x
5

DuPont Analysis

Decompose ROE into component drivers to understand what's driving returns.

DuPont Formula - Breaking Down ROE

ROE = Net Profit Margin × Asset Turnover × Financial Leverage
Net Profit Margin
14.3%
×
Asset Turnover
1.30x
×
Financial Leverage
1.34x
=
ROE
25.0%
Net Profit Margin

Measures profitability. TCS's 14.3% shows strong cost control in IT services.

Asset Turnover

Measures efficiency. 1.3x shows TCS generates ₹1.3 revenue per ₹1 of assets.

Financial Leverage

Assets/Equity = 1.34x. Low leverage shows conservative capital structure.

DuPont Insight

TCS's ROE is driven primarily by high profit margins and asset efficiency, not leverage. This is sustainable. Companies with high ROE from leverage alone (Financial Leverage > 3x) carry higher risk.

Ratio Calculator

Calculate key financial ratios for any Indian company

Financial Ratio Calculator

Key Takeaways

Profitability: Focus on ROE (>15%), ROCE (>12%), and EBITDA Margin trends. TCS excels with 25% ROE driven by margins, not leverage.

Leverage: Debt/Equity <0.5 for IT is safe. Interest Coverage >5 is comfortable. Watch for rising leverage trends.

Operating: DSO, DIO, DPO drive working capital. Cash Conversion Cycle shows operational efficiency. TCS CCC: ~26 days.

Valuation: Use P/E for profitability comparison, EV/EBITDA for leverage-neutral analysis, P/B for asset-heavy firms.

DuPont: Decompose ROE to understand drivers. Sustainable ROE comes from margins and efficiency, not leverage.

Modeling: Historical ratios form assumption base. Project margins, turnover, and working capital days for integrated models.

References & Tools

📚 Textbooks
  • Investment Analysis - Reilly & Brown (Page 345-380)
  • Financial Statement Analysis - Penman
  • Financial Modeling - Benninga
🌐 Indian Resources