Financial statements give us an idea about a company’s performance and health but more often than not, investors, creditors, analysts, and competitors wish to know where the company stands in the industry, as compared to its competitors. The analysis of the company’s performance in isolation is misleading, therefore, financial ratios analysis is used to compare a company’s performance with that of its competitors.
This brings us to an important question: What are financial ratios? Well, they are simply ratios of line items found in the financial statement that give an idea about a company’s profitability, leverage, liquidity, and market value. For example, the Debt-to-Equity ratio is used to analyze the extent of leverage the company has.
But before we get into the details, let’s first see how the ratios are grouped. The following chart depicts the grouping of financial ratios in five categories.
Each of these ratios tells about a particular characteristic of the company. Let’s understand each group one by one now.
These ratios indicate a company’s ability to generate profit relative to its sales, assets and equity capital. They are extremely helpful when comparing the profitability of businesses of different sizes because the profitability of a medium enterprise cannot be compared with that of a large business in value terms. Let’s take a look at them, now.
- Gross Profit Margin: It is the ratio of a company’s gross profit to net sales. Gross profit is obtained after subtracting cost of goods sold (COGS) from net sales.
Gross Profit Margin = (Net Sales – COGS) / Net Sales
COGS is the cost related directly to the manufacturing of a product, such as raw materials cost and workers’ wages. Selling and distribution cost, office and administration cost, employees’ salaries, etc are not included in the calculation of COGS. Therefore, gross profit margin tells us about how efficiently is COGS managed.
- Operating Profit Margin: It is an indicator of how efficiently a company’s operations are being run and is the ratio of operating profit (EBITDA) and net sales.
Operating Profit Margin = Operating Profit (EBITDA) / Net Sales
EBITDA stands for Earnings before Interest, Tax, Depreciation, and Amortization. It is obtained after subtracting all the indirect costs such as selling and distribution cost, office and administration cost, and employees’ salaries from the gross profit. A high operating profit margin indicates high operating efficiency.
- Net Profit Margin: It is the ratio of a company’s net profit to net sales. It is also known as PAT (Profit After Tax) margin.
Net Profit Margin = Net Profit (PAT) / Net Sales
- Return on Assets (ROA): It is a measure of a company’s ability to utilize its assets efficiently and is the ratio of net profit to total assets.
ROA = Net Profit (PAT) / Total Assets
A high value of ROA indicates that a company is able to utilize its assets to generate profit efficiently.
- Return on Equity (ROE): It is ratio of net profit to shareholders’ equity. This number is crucial for equity investors as it measures the profit it can generate from the equity investments made.
ROE = Net Profit (PAT) / Shareholders’ Equity
These ratios give us an idea about a company’s ability to repay its short-term liabilities. Short-term or current liabilities are liabilities that have to be repaid within one year. Some of the important liquidity ratios are:
- Current ratio: It is the ratio of current assets of a company to its current liabilities. It is the measure of a company’s ability to repay all its short-term liabilities by liquidating current assets. Receivables, cash and cash equivalents, and inventory are considered current assets. If the value of current assets is higher than that of current liabilities, then the company is in a better position to repay its current liabilities.
Current Ratio = Current Assets/Current Liabilities
Although, a current ratio greater than 1 is considered good, too high a value may also indicate an inefficient working capital cycle. Let’s take an example. Consider the following for a company ABC Ltd:
|Current Liabilities||Amount ($)||Current Assets||Amount ($)|
|Short-term loans||500||Cash and cash equivalents||1000|
|Accounts Payables||1000||Accounts Receivables||3000|
In this case,
Current ratio = 6000/1500 = 4
It may look like a very good current ratio, but let’s take a look at the working capital before jumping onto conclusions.
Working Capital = Account Receivables + Inventory – Account = 4000
A negative working capital is considered good, but in this case, it comes out to be $4000, which is positive and quite high. This means that the company will need to borrow some amount to keep the working capital cycle running, which will further increase the company’s current liabilities.
- Quick ratio or Acid-test ratio: For some businesses, current ratio may not be relevant if their inventories are illiquid, as is in the case of the real estate sector. Therefore, another ratio called the quick-ratio is used in such as case. It is given by the following formula:
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
By leaving out inventories in the calculation, an accurate picture about a firm’s ability to repay its short-term liabilities can be obtained. An ideal quick ratio is 1.
To understand leverage ratios in the financial context, let’s understand leverage in literal terms. Leverage basically is deriving maximum benefit by using minimum resources. In the context of a business, the benefit is net profit and the resource is capital. We know that capital is of two types i.e. equity and debt capital. In concordance with the principal of higher risk, higher return, the cost of equity capital is higher than the cost of debt, as equity shareholders take a greater risk by not expecting repayment of their capital or consistent payment of dividends. Therefore, businesses are leveraged using debt for two reasons:
- The cost of debt i.e. the interest paid on it is lower as compared to dividends paid on equity shares
- Interest paid on debt is recorded as an expense in the profit and loss statement and is tax deductible
Due to these reasons, businesses are attracted towards debt as a source of capital. Now, let’s look at some of the leverage ratios.
- Debt-to-Equity Ratio: As the name suggests, it is the ratio of total debt or liabilities to shareholders’ equity.
Debt-to-Equity Ratio (DE) = Total Liabilities / Shareholders’ Equity
According to the argument made above, one would say that a very high DE ratio is advisable. However, high debt implies high risk of default. If the company fails to pay the interest and principal amount regularly, we might see the business in the bankruptcy court. On the contrary, a DE ratio lower than 1, shows that the company is really leveraging its potential to carry debt.
This also brings us to a crucial point, which is that there is no ideal DE ratio. It varies with the industry in which a certain business works. A capital-intensive industry such as the steel industry will have a higher DE ratio as compared to that of the IT industry.
- Interest Coverage Ratio (ICR): This ratio indicates how effectively a business is able to meet its interest expenses.
Interest Coverage Ratio = Operating Profit (EBIT) / Interest Expenses
Generally, a high ICR is recommended as it shows that the business is able to repay its interest obligation easily, which is something a bank would be looking at.
- Debt Service Coverage Ratio (DSCR): It is the measure of a business’ ability to meet its debt obligations. Debt obligations include both interest and principal amount.
DSCR = Operating profit (EBITDA) / (Interest + Principal amount)
A business that has debt, has to pay not only interest but also the principal amount. Therefore, a high DSCR shows that a company can meet its debt obligations easily.
These ratios give us an idea about the efficiency or effectiveness of a company’s management in managing its working capital cycle and utilizing its assets. Businesses often work on credit i.e. ‘Udhaar’. The business buys raw material from the suppliers on credit and in turn sell the final product to customers on credit but always, not all of the final products are sold. Some lie in the company’s warehouse till they are sold.
Therefore, the cash spent by the company on the manufacturing of the final product remains locked in the inventory and receivables from the customer. At the same time, the company has to pay cash to the raw material suppliers within the credit period. This entire cycle of converting the inventory, receivables and payables to suppliers in cash is called the working capital cycle.
Now, let’s take a look at these ratios.
- Inventory Turnover Ratio (ITR): This ratio is a measure of number of times a company is able sell its inventory in a specified period.
ITR = Cost of Goods Sold (COGS) / Average Inventory
Think of it this way: Final products worth $1000 arrive into the company’s warehouse. After some days, all of it is sold and a new batch of final products of the same amount arrives. The inventory turnover ratio basically tells us how many times the company repeats this process in a specified time period. A high ITR indicates that the inventory is being sold immediately and vice versa. A very high ITR is not always good because if there is an unusual spike in demand, the company will not be able to supply products to its customers and it may lose some of them.
- Receivables Turnover Ratio: It is the measure of the number of times a company is able to turn receivables into cash in a specified time period, which in simpler terms means how many times is the company able to ‘Vasool’ its ‘Udhaar’ from its debtors (read customers).
RTR = Credit Sales / Average Account Receivable
A high RTR indicates that a business is able to turn its receivables into cash frequently but it could also lead to losses, as customers may prefer to go to a competitor simply because it offers a longer credit period.
- Payables Turnover Ratio (PTR): It is the measure of the number of times a company is able to pay its payables in a specified time period i.e. how many times is the company able to pay its ‘Udhaar’ to its suppliers.
PTR = Credit Purchases / Average Accounts Payable
A low PTR indicates that the business is paying the suppliers less frequently, which gives the business sufficient time to convert inventory and receivables in to cash and pay the suppliers using the same cash. However, too long a credit period will affect the suppliers’ businesses and they may start supplying to a competitor.
- Fixed Asset Turnover Ratio (FATR): It is the measure of a business’ ability to utilize its fixed assets to generate revenues.
FATR = Net Revenue / Total Fixed Assets
A high FATR indicates that the company is able to generate large revenues from its fixed assets. It shows how efficiently the company is utilizing its fixed assets. A low FATR usually is characteristic of a capital-intensive business.
Market Value Ratios
These ratios are used to understand if the market price of a share is overvalued or undervalued relative to the underlying fundamentals of the company. Investors also compare companies within the same sector using these ratios. Therefore, they are also known as relative valuation ratios. Stock market investors keenly observe these ratios to find a stock that is undervalued. Now, let’s take a look at some of these ratios.
- Price-to-Earnings Ratio (PE): It is the ratio of current market price of a company’s share and its earnings per share (EPS). You might be wondering what EPS is, right? But don’t worry, it’s not at all complicated. It is the ratio of the net profit of the company to its total number of shares.
EPS = Net Profit (PAT) / Total No of Shares Outstanding
Once, we have the value of EPS, we can easily calculate the PE ratio for a company.
PE Ratio = Current Share Price / Earnings per Share (EPS)
Theoretically, a stock that has a PE ratio greater than 1 is considered overvalued and vice-versa but for all practical purposes PE ratio is used while comparing between competitors to see if the PE ratio of one company is overvalued or undervalued relative to its peers’ PE ratio.
- Price-to-Book Ratio (PB): It is the ratio of current market price of a share to the book value per share of a company. Book value is the amount that remains after all its assets are liquidated and its debt obligations are paid off.
Book Value per Share = (Total Assets – Total Liabilities) / Total No of Shares Outstanding
Book value per share is calculated using the above formula, following which the PB ratio can be easily calculated.
PB Ratio = Current Share Price / Book Value per Share
It is used in a similar way as the PE ratio is used by investors to compare multiple businesses, however, PB ratio is helpful only in capital-intensive businesses. In comparing service sector businesses, due to their low asset value, this ratio becomes irrelevant.
This piece has been penned down by Shivam Ghule, Finance Tolkien of CaseReads. If you want to understand the calculations of the above ratios, we have added a live example of a company. To access the file, click below:
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