RATING APPROACH – Financial Ratio Analysis of Entities in the Non-Financial Sector

September 2022
This document updates and supersedes ICRA's earlier document on this subject,
published in September 2020.

Overview
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ICRA’s credit ratings are a symbolic representation of its opinion on the relative
credit risk associated with the debt instrument being rated. This opinion is
formed after evaluating an entity’s industry, business and financial risks, its
liquidity and financial flexibility, the management’s financial policy, its corporate
governance practices, and support from group entities. This document gives a
description of the salient financial ratios assessed by ICRA for evaluating the
financial risk profile of entities in the non-financial sector. These financial ratios
are the commonly used ones. In addition to these, a variety of sector-specific
ratios, as described in the various sector-specific methodologies published by
ICRA, are also evaluated as part of ICRA’s analytical approach to credit risk
Table of Contents: assessment.
Overview .............................................. 1
Profitability ........................................... 2 As a broad principle, ICRA’s analytical approach centres on the following three
Leverage ............................................... 4 elements:
Coverage............................................... 7
Liquidity ................................................ 8 » Longer period analysis: The financial risk analysis is not undertaken solely
Summing Up ....................................... 10 based on the latest available ratios as it may cause a point-in-time analysis
bias for reasons such as recent capital expenditure, recent fresh capital
infusion and so on—that may skew the ratios one way or the other. To assess
ANALYST CONTACTS the financial risk profile of an entity, ICRA analyses its long-period
performance trends of the past as well as draws projections for the expected
Mr. K. Ravichandran
performance in future. While the relevant period of analysis may vary from
Executive Vice President and
Chief Rating Officer case to case and/ or sector to sector, as a general practice, at least five years
+91 22 6114 3408 of past financials and around three years of projections are analysed.
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» Comparison with peers: The analysis is meant to gain an understanding of

Mr. Jitin Makkar
Senior Vice President how the financial metrices of the rated entity compare with that of its peers,
+91 124 4545 368 rather than the entity being assessed in isolation. After all, ratings are relative
[email protected] measures of credit risk and an analytical process that involves a comparison
with peers supports the ethos of rating consistency. While the rating scale
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(AAA to D) remains common across sectors, the yardsticks for undertaking
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+91 124 4545 801 comparative performance may vary between sectors and hence ‘comparison
[email protected] with peers’ is to be understood as a comparison among entities belonging to,
at the very least, the same sector.

» Standard adjustments: When comparing entities, suitable adjustments are

made to the way some of the reported items in the profit and loss and the
balance sheet statements are classified. These could relate to simple

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 ICRA Rating Methodology Financial Ratio Analysis

adjustments such as making classification distinctions between the operating income and the non-operating income, to the
more esoteric ones such as forking out hybrid instruments into debt and equity. This is intended to ensure a like-to-like
comparison of the financial ratios among entities.

It is also necessary to emphasise that a credit rating exercise, that includes a financial ratio analysis, is not an audit and
hence if some managements practise corporate legerdemain, and the rating fails later, it need not reflect a failure of one’s
analytical ability.

The various financial ratios discussed in this document have been divided into four categories viz., profitability, leverage,
coverage and liquidity. Profitability metrics are a measure of an entity’s efficiency and return on investments. Leverage
ratios measure the indebtedness of an entity. Coverage ratios measure the factor of safety between the inflows and the
debt servicing obligations. Finally, liquidity ratios measure the buffer that an entity has in the form of various internal and
external sources of cash, which could be utilised in case of any temporary cash flow mismatch, for meeting the near-term
obligations.

Profitability
What does it signify? Profitability is a measure of the earnings generated by an entity in the period of analysis in relation
to its income or the resources deployed. Profitability could be influenced by a multitude of factors including those that are
firm-specific or those that are related to the economy, industry, or regulations. A consistent track record of higher
profitability shown by an entity compared with its peers reflects a superior competitive position arising from one or more
factors, including greater brand strength, better distribution reach, attractive product profile, technological superiority, or
higher cost efficiency (operating or capital).

Why is it important? It is imperative for most businesses to invest regularly in product development, research, advertising,
and various tangible and intangible assets to sustain or improve their competitive position. Entities that have superior
profitability can do so through internally generated resources with low dependence on external financing. Moreover, such
entities can generate sufficient surplus for not only meeting debt servicing obligations, but also to reward equity investors.
This in turn improves their ability to attract fresh capital for future business requirements. However, an entity may be
investing more money than it is making, resulting in negative free cash flows. Such an entity might have continued
dependence on external financing in the near to medium term. Yet, this need not necessarily be a credit negative if the
pay-off on investments is high to the extent that profitability (read Return on Capital Employed) well exceeds the cost of
capital.

The various ratios which are typically used to analyse an entity’s profitability are discussed below:

Operating Profit Margin

Operating Profit Margin (OPM) is a measure of an entity’s pricing power and/ or operating efficiency. This ratio is not
affected by the entities’ capital structure, the depreciation policies, the tax systems, or sources of non-core income. Hence,
this ratio is a useful metric in comparing the margins of entities arising from their core business. Yet, the OPM does get
influenced by business model choices. To illustrate:

» An entity may choose to pay to its suppliers quickly, seek supplier discounts and fund its working capital requirements
through borrowings, while another may fund its working capital requirements by pushing back payments to creditors
against which it foregoes discounts to its suppliers. The reported operating profits (and OPM) are likely to be higher in
case of the former, even as these may be offset at the net profit level in view of the former’s relatively higher
borrowings and hence higher interest outgo.
» The OPM between two entities in the same broad sector may also differ following differences in their product mix and
‘make versus buy’ choices in their supply chains.

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Further, ICRA recognises the limitations of OPM in its role as the headline margin metric. In the analysis of commodity
businesses, for instance, the OPM analysis is complemented by a contribution analysis. This becomes relevant to delineate
the impact on margins caused by the movement in the spread between the price of the produce and the raw material costs,
and the movement in other operating costs. The above aspects are appropriately factored-in by ICRA while making inter-
entity OPM comparisons. Moreover, the OPM is also driven by the capital intensity of the business in which the entity
operates, as the entities which are present in capital intensives businesses need to earn higher operating profit (and thus
OPM) to cover for relatively higher capital costs, which limits the utility of OPM for cross-sectoral comparison.

Net Profit Margin

Net Profit Margin (NPM) is a measure of the earnings generated by an entity after charging-off all operating and non-
operating expenses, capital costs (depreciation and financial expenses) and taxes. Holding all else equal, two entities having
the same OPM may have different NPM if one entity part-funds its business through debt while the other chooses to remain
debt-free. The net profits (and NPM) of the former will be lower as it would need to pay out a part of its profits as interest.
From a credit perspective, an entity that has higher NPM would accordingly be relatively safer, all else being equal. Yet, an
entity that reports higher margins as it follows a premium pricing strategy need not always be better than an entity whose
business model hinges on low margins but high volumes, as despite the former’s higher margins, its profits may fall short
of the business requirements for investment and debt servicing. Effectively, while NPM comparison across entities does
provide a perspective on relative returns, this is assessed by ICRA against the backdrop of business characteristics and
strategic choices made by entities.

Return on Capital Employed

Return on Capital Employed (RoCE) is a measure of the efficiency with which an entity sweats the capital deployed in its
business. This ratio is influenced not just by the factors that influence the profit margins (viz., pricing power/ policy and/ or
operating efficiency), but also by the level of asset utilisation. This ratio measures how well the capital which has been
deployed in the business has been put to use, irrespective of the source of the capital or the extent of the capital which has
been deployed, and thus could be used to compare entities across diverse businesses and with different capital structures.
When ICRA undertakes a comparative analysis of the level of RoCE demonstrated by entities, it does so against the backdrop
of the fundamental business risk attributes of the entity, besides the track record of volatility in RoCE shown over the years.

Business Risk and RoCE: An entity may be commanding a relatively high RoCE, but that might be because it operates in a
relatively high-risk business. This necessitates drawing out the meaning of RoCE on a business risk-adjusted basis (which is
analogous to tracking the spread between the RoCE and the cost of capital). Conversely, a numerically low RoCE may be
the outcome of the entity’s operations in a low-risk sector, even as the entity’s RoCE might be relatively higher than its
peers. In such situations, a low absolute RoCE is not considered a reflection of weak business positioning within the sector
that the entity operates in. In another setting, a high RoCE may be an outcome of a business model oriented towards a lean
supply chain and just-in-time inventory controls. However, a supply chain shock because of crystallisation of some discrete
event could disrupt the business and make the extreme focus on operating efficiency look a highly risky business choice.

Volatility in RoCE: A track record of a highly volatile RoCE shown over the years could be because of an infirm business
position or presence in a cyclical industry. The RoCE of an entity may slide in a given year if it undertakes a large capital
expenditure (capex) programme or pursues an acquisition. However, ICRA does not necessarily perceive this as a credit
negative, if in its assessment, the capex or the investment is estimated to generate adequate returns in the future.

ICRA also appropriately considers the impact on RoCE of an entity’s policy or practice of stretching payments to its suppliers
and service providers, which may give the impression of healthy profitability but mask the reality of tight liquidity.
The above aspects are appropriately factored-in by ICRA while analysing the RoCE metric.

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Ratio Computation
Operating profit margin (Operating profit) / (Operating income)
Net profit margin (Net profit after tax) / (Operating income)
Return on capital employed (Profit before interest and tax) / (Average capital employed)

Operating Income = Revenues from Operations (net of indirect taxes)

Operating Profit = Profit before Depreciation, Amortization, Interest, Tax and Non-Operating or Non-Recurring Income and
Expense

Capital Employed = Total Debt + Net Worth + Deferred Tax Liability – Capital Work in Progress – Capital Advances

Leverage
What does it signify? Leverage, shorthand for financial leverage in this note, is a measure of an entity’s dependence on
borrowed funds. Lower the dependence on borrowings, the lower (better) the leverage. When an entity borrows, it is
obligated to pay both interest as well as principal to the lenders as per a defined schedule. This pushes up the fixed cost
burden on the borrowing entity and in the limiting case, increases the default risk. While high leverage may mean high risk
from a credit perspective, it is an oft-adopted course by shareholder-oriented managements given that high leverage, in
good times, leads to high returns on equity capital. An entity’s financial leverage could thus be a function of its
management’s financial policy and risk tolerance, besides being a point-in-time reflection of an entity’s business and
financial choices.

Why is it important? Since borrowed funds typically have fixed obligations in the form of interest and principal payments
irrespective of the level of cash flow generation, as against equity capital where there are no fixed obligations and pay-outs
remain discretionary, leverage denotes the extent of financial risk taken by an entity. An entity with lower leverage typically
has higher financial flexibility to raise incremental external capital (debt or equity) for re-investment in business or other
purposes. An entity with lower leverage is also better equipped to withstand volatility in cash flow generation in situations
of economic downturn, competitive challenges, unexpected rise in costs, changing consumer preferences, or regulatory
changes. Compared with stable or mature industries, cyclical industries or those with higher volatility in cash flows have
lower tolerance to financial leverage, lest it should increase the proportion of fixed financial expenses in their cost structure,
thereby increasing the probability of default.

However, there may be exceptions to this such as in project funding structures for long-dated assets like road projects,
power projects or hotel projects where the loan tenures are typically long. In such cases, even as profit generation may
remain weak in the initial years of the project and leverage ratios may appear high, the fact that the long-term debt
contracted may have a sufficiently long period of moratorium (and interest pay-out during the construction phase may also
be funded through the project debt) along with a ballooning and a spread-out repayment schedule, the financial profile is
likely to remain adequate.

The various ratios that are typically used to analyse an entity’s leverage are discussed below:

Gearing
Gearing is a commonly used measure of leverage and is defined as the ratio of borrowed funds to shareholders’ funds.
While ascertaining borrowed funds, ICRA considers all the long-term and short-term debt, as well as off-balance sheet
liabilities such as receivables discounted1 for an entity. While ascertaining shareholders’ funds, ICRA adjusts the net worth

1 Receivables which have ultimate recourse on the entity which is discounting the receivables

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for revaluation reserves, miscellaneous expenditure, which has not been written off, to arrive at the tangible net worth as
it gives a more accurate representation of the amount of funds that have the first loss absorption capacity. Moreover, the
minority interest, which represents the share of non-controlling shareholders in a consolidated entity, is also included in
the shareholders’ funds. Deferred tax liability is not included in the shareholders’ funds as these arise from timing
differences between book profits and profits computed as per the Income Tax Act, which are expected to be reversed
eventually. Apart from these, ICRA makes appropriate adjustments to assign equity credit to various hybrid instruments 2,
such as convertible debentures, preference shares and perpetual debt, depending on their contractual terms. In addition,
ICRA also nets-off from the gross debt, the cash reserves that are earmarked for servicing specific debt instruments (and
likewise for cash margins for non-fund-based limits from the total outside liabilities), to estimate the net leverage ratios.
While gearing is a useful metric to know the mix of capital used to fund the entity’s assets, a high or a low ratio need not
always indicate a strong or a weak financial profile and is looked at on a case-by-case basis.

When low gearing isn’t necessarily a virtue

Consider a sample balance sheet presented in the table below. The example entity is constrained to make investments in
group entities out of owned funds as the lenders are unwilling to sanction loans for making such investments. Further,
assume that the margin on working capital borrowings for funding the current assets is 25%, the margin on term loans for
the purchase of fixed assets is 20%, and the investment in group entities is to be funded entirely through net worth.

Assets Liabilities
Net Fixed Assets 40 Net Worth 248
Investments in Group Entities 200 Working Capital Loan 120
Debtors 100 Term Loan 32
Inventories 60
TOTAL 400 TOTAL 400

For the above balance sheet, what should be the minimum net worth?

Net worth requirement = 25% margin on current assets of 160 units + 20% margin on net fixed assets of 40 units + entire
investments in group. Thus, the total minimum net worth required for the business is 248 units. Accordingly, the gearing
of the entity is computed as 0.6 time (=152/ 248). However, such seemingly low gearing need not be considered a credit
positive as, by design, this is the maximum gearing that the entity can have. Rather, in such cases, assessing the adjusted
gearing (adjusting for investment in group entities) would be more relevant. The adjusted gearing in this case is computed
as 3.2 times (=152/ 48), a high ratio.

2 The detailed rating approach on the Hybrid Instruments can be referred at www.icra.in

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Adjustment for encumbered cash

An entity may be required to maintain encumbered fixed deposits (or cash balances) as part of say, the Debt Service Reserve
Account (DSRA) or as margin funding for non-fund-based limits. Such deposits are only available to be utilised for servicing
the specific obligations for which they are specifically earmarked. ICRA makes the following adjustments with respect to
encumbered deposits:

a. If deposits can be utilized on or before the due date of debt servicing

ICRA considers such deposits as a source of liquidity while evaluating the liquidity profile of the entity/ debt
instrument being rated.

b. If deposits can be utilized only after the due date of debt servicing

In this scenario, the encumbered deposits merely act as a security for the benefit of the financial creditors against
the total outstanding obligations. Thus, to represent the entity’s net obligations, ICRA nets-off such deposits from
the gross debt (and likewise for cash margins for non-fund-based limits from the total outside liabilities).

Total Indebtedness Ratio

Total indebtedness ratio is defined as the ratio of all external liabilities to shareholders’ funds or the market capitalisation
(if the entity’s equity is publicly listed). The external liabilities include all the long-term and short-term liabilities such as
debt, deferred tax liability and creditors. This ratio normalises the impact of funding difference among entities with respect
to their use of fund-based and non-fund based facilities. Since non-fund based lines of credit are not reported under
borrowed funds (unlike fund based facilities), an entity that relies primarily on non-fund based lines of credit for funding
its working capital requirements or has extended credit terms with its suppliers and service providers will appear to have a
lower (better) gearing as compared with an entity that utilises fund-based lines of credit such as cash credit limits. The total
indebtedness ratio addresses this aspect, as external liabilities include fund-based limits, non-fund based liabilities and
creditors.

Debt to Profit Ratio

Debt to profit ratio is defined as the ratio of borrowed funds to operating profits and denotes the extent of leverage in
relation to profits. As debt is typically required to be serviced from operating profits (unless refinanced or paid through
other internal or external resources), this ratio measures an entity’s susceptibility to volatility in profits. However, as debt
servicing includes both interest and principal payments, this ratio is seen in conjunction with the average cost, tenor and
repayment schedule of the borrowed funds as two entities having similar debt-to-profit ratio could have different financial
risk profiles, depending on the financing cost, tenor and the repayment schedule. As an example, for two entities with
similar debt levels, the entity having a longer repayment schedule can utilise the profits generated over a longer tenure to
service the debt and thus can sustain a higher debt-to-profit ratio compared to an entity with a shorter repayment period.

Accruals to Debt Ratio

It is defined as the ratio of cash accruals to borrowed funds and its reciprocal is an indicator of the number of years required
to repay the borrowings with the existing level of accruals. For calculating cash accruals of an entity, depreciation is added
back to net profits and dividend pay-outs to equity and preference shareholders are charged off. Although the debt holders
rank higher than the shareholders in terms of priority of claims, this ratio attempts to assess the debt servicing ability of an
entity while assuming dividend pay-outs to be non-discretionary and recurring. This ratio is particularly useful to analyse
entities, most of whose debt is amortising in nature and dividends are expected to be sticky. Moreover, this ratio is seen
along with the average maturity profile of the debt. Notwithstanding high accruals to debt ratio for an entity, lower average
maturity profile of debt could reflect a difficulty in meeting the debt servicing obligations at the existing levels of cash
accruals, implying that the entity might have to depend on external funding support or refinancing, for debt servicing.

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Ratio Computation
Gearing (Total debt) / (Tangible net worth)
Total indebtedness ratio (Total outside liabilities) / (Tangible net worth)
Debt-to-profit ratio (Total debt) / (Operating profit)
Accruals to debt ratio (Net cash accruals) / (Total debt)

Total Debt = Long-Term and Short-Term Debt + Off-Balance Sheet Liabilities (such as receivables discounted) + debt
component of hybrid instruments as assessed by ICRA based on the instruments’ contractual terms

Shareholders’ Funds or Tangible Net Worth = Net Worth - Revaluation Reserves - Miscellaneous Expenditure not Written-
off + Minority Interest + Share Application Money + equity component of hybrid instruments as assessed by ICRA based on
the instruments’ contractual terms

Total Outside Liabilities = Total Debt + All Long-Term and Short-Term External Liabilities such as Deferred Tax Liability,
Creditors and Operating or Non-Operating Liabilities

Net Cash Accruals = Net Profit after Tax + Depreciation – Dividend on Preference and Equity Shares

Coverage
What does it signify? Coverage is a measure of an entity’s debt-servicing ability and is calculated as the ratio of profits (or
cash flows) to the debt servicing obligations in the period of analysis. The higher the ratio, higher is the cushion available
with an entity to withstand the variability in profits (or cash flows), for making good its financial obligations. Coverage is a
function of an entity’s profits, leverage and debt characteristics (in terms of cost of debt and repayment schedule).

Why is it important? Entities with higher profitability and lower leverage will generally have better coverage ratios and
thereby healthier financial risk profiles. The coverage ratio, however, needs to be seen in conjunction with the riskiness of
the business in which the entity operates. A risky business is prone to volatility in earnings, and thus needs a higher cushion
to tide over period of downturns. On the other hand, a business with stable regular income can operate at lower coverage,
while maintaining a healthy financial profile. In case the coverage ratio of an entity is below 1.0 time in the period of
analysis, it may have to seek recourse from other sources of liquidity—such as cash balances or liquid investments or equity
infusion or undrawn working capital limits or resort to refinancing the loans—to avert a situation of default on debt
servicing. However, a ratio of less than 1.0 time does not always indicate a stressed financial position as it may have high
financial flexibility to timely refinance and thus, this ratio should be seen in conjunction with the financial flexibility of an
entity.

The various ratios that are typically used to analyse an entity’s coverage are discussed below:

Interest Coverage Ratio

Interest coverage ratio is defined as the ratio of operating profits to gross interest expense (without netting off the interest
income from loans and advances) and is an indicator of an entity’s ability to cover the ongoing cost of borrowed funds
through the profits generated from operations. An entity with an interest coverage ratio of less than 1.0 time would
generally be unable to service even the cost of borrowed funds and thereby would be exposed to a high probability of
default. For such entities, the capacity to raise fresh funds would also be constrained which in turn may adversely impact
the long-term viability. On the contrary, for an entity with an interest coverage ratio of 10 times, its profits will need to fall
dramatically before becoming insufficient to make good the interest payments. An apparently comfortable interest
coverage ratio, however, does not reveal whether the entity would have a surplus left, after making interest payments, to

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repay the principal portion of the debt as it becomes due or to fund the margin required for a proposed large capex outlay.
Nevertheless, this ratio is of relevance in case of entities where most of the debt is non-amortising in nature.

Debt Service Coverage Ratio

Debt Service Coverage Ratio (DSCR) is defined as the ratio of internal accruals to the debt servicing obligations and is an
indicator of an entity’s ability to meet all the fixed financial obligations on the borrowed funds (interest, principal
repayment and dividend on preference shares) from its internal accruals. A ratio of more than 1.0 time indicates that the
entity will be able to meet its obligations from internal accruals, while a ratio of less than unity indicates a shortfall and a
possible dependence on timely refinancing.

A similar cash flow-based ratio is the cash debt service ratio, which is defined as the ratio of operating cash flows after
adjusting for the changes in working capital to the debt servicing obligations. It is an indicator of an entity’s ability to cover
for all the fixed financial obligations on the borrowed funds (interest, repayment and dividend on preference shares) from
its operating cash flows’ net of working capital changes. As profits often do not equal cash, as funds may be blocked in
working capital, a cash flow ratio such as this is generally a better indicator of the debt servicing ability of an entity.
However, a weak cash debt service ratio does not necessarily indicate a weakness in financial risk profile because the ratio
assumes that the entire working capital requirement would be funded from operating profits, which may not always be the
case.

For a growing business, the incremental working capital requirement is generally funded though both operating profits as
well as fresh borrowings. Nevertheless, a higher ratio in a stable or a growing business is generally indicative of a healthy
financial risk profile and implies sufficient cash flow availability for re-investment in business. Likewise, in a declining
business, even if this ratio appears comfortable, it may only be the outcome of release of working capital even as underlying
profits may be on a declining curve. In such cases, while a positive cash debt service ratio would indicate no immediate
pressure on the debt servicing ability, this situation may not sustain if the business and profits keep declining in such a
manner that liquidity pressures eventually catch up.

Ratio Computation
Interest coverage ratio (Operating profit) / (Gross interest expense)
(Net profit after tax + Gross interest + Depreciation) /
Debt service coverage ratio
(Gross interest + Repayment + Dividend on preference shares)

Liquidity
What does it signify? Liquidity is the measure of an entity’s ability to meet its short-term cash obligations from various
internal or external resources. Internal resources include the cash generated from operations, unencumbered cash and
cash equivalents on hand, and cash inflows expected from the monetisation of physical and financial assets. External
resources include various forms of external capital such as undrawn working capital limits, short-term loans, project loans
and corporate loans from financial institutions, and fresh equity capital committed to be brought in by promoters or a third-
party. The short-term obligations include both the committed as well as the contingent claims on an entity’s cash, including
the debt servicing obligations, working capital requirements, capital expenditure and other investment outlays, dividend
and share buyback-related outflows, besides the sudden demand arising from crystallisation of discrete events such as
litigation penalty. The higher the cushion available between the resources available (especially internal resources) and the
obligations, the better is the liquidity profile of an entity. In addition to the adequacy of internal and external resources,
liquidity profile is also driven by the vulnerability of an entity to timely refinancing / renewal of short-term sources of
funding.

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Why is it important? Given that the prospect of healthy long-term fundamentals may not mean much for an entity if crisis
looms in the short-term, liquidity analysis remains a crucial element of credit analysis. To assess the ease with which an
entity can access cash or cash equivalents, one is interested in metrics beyond leverage. Low leverage does not necessarily
indicate low default risk as an entity may find itself short of liquid assets—for conversion to cash quickly and cheaply—to
meet its impending cash obligations. In addition, while cash flow analysis assesses the adequacy of an entity’s internal
resources and committed external sources of financing in relation to its obligations, it does not distinguish between the
nature of such cash flows. In other words, cash flow analysis does not specifically capture whether it is the long-term
sources of funds that are deployed towards the creation of long-term assets, including fixed assets, long-term investments
and long-term loans and advances, or it is the short-term funds. In cases where short-term sources of funds (such as working
capital limits, short-term loans and customer advances) are deployed for long-term purposes, liquidity of an entity remains
vulnerable to timely refinancing or renewal of the short-term sources of financing. ICRA also notes that the measures of
liquidity can become outdated quickly and hence an entity’s management’s approach to deal with the trade-off between
returns and liquidity is accorded due importance in ICRA’s analytical approach.

The various ratios, which are typically used to analyse an entity’s liquidity are discussed below 3:

Current Ratio
Current ratio is defined as the ratio of current assets to current liabilities and is an indicator of an entity’s long-term funding
adequacy. Generally, the higher the current ratio, the lower is the mismatch between the long-term requirement and the
long-term sources of funding. The ratio is analysed after adjusting for the long-dated receivables and obsolete inventory as
these may not be readily convertible to cash and are generally ineligible for short-term bank funding. A related aspect is
evaluation of receivable and inventory ageing to appropriately estimate the long-term funding requirements as well as to
assess the possibility and extent of write-off that may be required towards these assets. In addition to the ageing analysis
for current assets, the quality of receivables is also assessed to determine the likelihood of timely collection of such
receivables. Significant proportion of unsecured receivables concentrated among a few entities with weak or
unascertainable credit profile poses a bigger risk compared to a diversified distribution of receivables or concentration
among entities with a stronger credit profile.

Working Capital Cycle

The working capital cycle captures the amount of time taken by an entity to convert its net current assets (receivables and
inventory net of payables) into cash. The longer the working capital cycle, the greater the working capital funding
requirement for an entity and vice-versa. Typically, entities in a growth phase that have a shorter working capital cycle will
have a better liquidity profile because of faster cash turnaround, and thereby lower incremental working capital
requirements. In addition, such entities will have a lower proportion of long-dated receivables and inventory, which will
limit the risk of write-downs on such assets in the future.

However, one of the analytical issues while assessing the working capital cycle relates to distinguishing between entities
whose favourable working capital cycle is because of the inherent efficiency in working capital management and those
where a favourable working capital cycle is an outcome of stretching of payables. The latter may be a reflection of liquidity
stress rather than an indication of the bargaining power with business partners or efficiency in working capital
management. In such a situation, an entity may find itself in a deeper liquidity crisis whenever such liberal credit terms are
snapped.

In other cases, an entity may be relying solely on non-fund based limits (such as Letter of Credit) to manage its working
capital requirements (instead of fund-based working capital limits). In such cases, if the gross operating cycle (Receivable
Days + Inventory Days) is longer than the tenure of the non-fund based limits, the entity may find itself in a tight liquidity

3 The detailed rating approach on Liquidity Analysis can be referred at www.icra.in

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 ICRA Rating Methodology Financial Ratio Analysis

position as the time required for conversion of current assets into cash will be longer than the tenure of the underlying
current liabilities.

Apart from the length of the working capital cycle, the liquidity assessment also involves analysing the stability of an entity’s
working capital cycle. A declining working capital cycle, combined with improving operating profit margins, is generally
indicative of the efficient working capital management as well as improvement in bargaining power with the business
partners and vice versa.

Working Capital Intensity

Working capital intensity is an extension of the Working Capital Cycle measure as it also captures the cash turnaround rate
of an entity. However, while the Working Capital Cycle captures the cash turnaround rate with respect to only debtors,
inventory and creditors, working capital intensity captures the turnaround rate with respect to an entity’s entire working
capital, which also includes operating and non-operating current assets as well as liabilities. The ratio is expressed as a ratio
of the net working capital to the operating income. Moreover, the higher the ratio, the higher is the cash turnaround time
and thereby the working capital requirement for every unit of sale.

Ratio Computation
Current ratio (Current assets) / (Current liabilities)
Working capital cycle Debtor days + Inventory days – Payable days
Working capital intensity (Net working capital) / (Operating income)

Current Assets = Cash + Inventory + Debtors + Other Operating and Non-Operating Current Assets

Current Liabilities = Current Portion of Long-Term Debt + Short-Term Debt (including Working Capital Debt) + Creditors +
Other Operating and Non-Operating Current Liabilities

Net Working Capital = (Current Assets – Cash) – (Current Liabilities – Current Portion of Long-Term Debt – Short-Term Debt
– Capital Creditors)

Summing Up
This note discusses the various financial ratios, which are generally assessed by ICRA to evaluate an entity’s financial risk
profile. As each financial ratio captures different aspects of the financial risk, none of them alone can reflect the financial
risk of an entity in its entirety, and thus a collective analysis is undertaken to take a holistic view of the financial health of
an entity. Moreover, while financial risk is an important factor in determining an entity’s creditworthiness, it is not the only
driver of an entity’s credit rating as other factors such as business risk, management’s financial policy, support from group
entities and corporate governance practices also have a large role to play. Thus, even as an entity may report strong
financials, its credit rating may still be constrained if its business risk is high or it follows a less transparent corporate
governance structure. On the other hand, strong financial flexibility or backing from stronger group entities could mitigate
the impact of weak financials and support an entity’s credit profile.

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Today, ICRA and its subsidiaries together form the ICRA Group of Companies (Group ICRA). ICRA is a Public
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