Lesson #13: Ratio Analysis

Value Investing Masterclass - Safal NiveshakSo far we have seen the financial statements in isolation and how they depict different aspects of the businesses.

In order to get an accurate picture of company’s financial health and performance, you need to also evaluate the relationship between these financial statements. There are many relationships between the numbers – within one financial statement or between two or more statements.

Ratios are a useful way of expressing these relationships. They express one quantity in relation to another (usually as a quotient). By using ratios we can reduce the effect of size of a company, which enhances comparisons between companies (of diferent sizes) and over time.

Financial ratios are effective in selecting investments and in predicting financial distress. Investors and analysts routinely use ratios to communicate the value of companies and their stocks.

Please remember that the ratio is just an indicator of some aspect of a company’s performance, telling what happened but not why it happened.

Ratios can be categorized as under …

Ratio-category

We will not cover all the rations in this course, however Safal Niveshak’s Mastermind Course explains all the important ratios in detail.

Activity Ratios

Activity ratios are analyzed as indicators of ongoing operational performance – how effectively assets are used by a company. They generally combine information from the Income Statement in the numerator with Balance Sheet items in the denominator.

This is not the exaustive list of all the activity ratios but it’s good enough to get your feet wet.

1. Inventory Turnover

Inventory Turnover = Cost of Goods Sold / Average Inventory

Now, while no guideline exists for what is a good or bad inventory turnover ratio, it depends on what the company’s competitors are doing. For example the Inventory Turnover of Hero motors is 27 as compared to 22 for Bajaj Auto. This tells me that Hero is more efficient in turning around its inventory as compared to Bajaj.

The higher the inventory turnover ratio, the shorter is the period that inventory is held and so the lower is…

2. Receivables Turnover

Receivables Turnover = Revenue / Average Receivables

A relatively low receivables turnover ratio would typically raise questions about the efficiency of the company’s credit and collections procedures.

3. Payables Turnover

Payables Turnover = Cost of Goods Sold / Average Trade Payables

A payables turnover ratio that is high relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. An excessively low payables turnover ratio could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms. This is another example where it is useful to look simultaneously at other ratios.

4. Working Capital Turnover

Working Capital Turnover = Revenue / Average Working Capital

A high working capital turnover ratio indicates greater efficiency.

Liquidity Ratios

An analysis of a company’s liquidity focuses on its cash flows, and measure its ability to meet short-term obligations. Liquidity measures how quickly assets are converted into cash.

Let’s look at some of the liquidity ratios –

1. Current Ratio

Current ratio expresses current assets (assets expected to be consumed or converted into cash within one year) in relation to current liabilities (liabilities falling due within one year). So the formula is…

Current ratio = Current assets / Current liabilities

A higher ratio indicates a higher level of liquidity (i.e., a greater ability to meet short- term obligations).

2. Quick Ratio

Apart from current ratio, investors and analysts also apply a more stringent test of liquidity by calculating the quick ratio, or acid test ratio.

This considers the quick assets – only cash and current assets that can be most quickly converted to cash (marketable securities and receivables). The formula is…

Quick Ratio = (Cash + Current Investments + Receivables) / Current Liabilities

In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than the current ratio.

Solvency Ratios

While Liquidity Ratios help measure a company’s ability to meet short-term obligations (how quickly assets are converted into cash), Solvency Ratios help assess a company’s ability to fulfil its long-term debt obligations.

1. Debt-to-Equity Ratio

This ratio measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50%.

2. Interest Coverage

This ratio measures the number of times a company’s EBIT (earnings before interest and tax) could cover its interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds) from operating earnings.

One of the most important things to identify whether a business has competitive advantages over its competitors or not is to look at its profitability. Profitability is a key determinant of a company’s overall value and the value of the securities it issues. Profitability of a company can be measured by calculating a few profitability ratios, which measure the return earned by the company during a period.

Profitability Ratios

Let’s look at few Profitability Ratios. Remember that for each of the profitability ratios, a higher ratio indicates greater profitability.

1. Gross Profit Margin

Gross profit margin indicates the percentage of revenue available to cover operating and other expenditures. The formula is…

Gross Profit Margin = Gross Profit / Net Sales

Here, Gross Profit = Net Sales – Cost of Goods Sold or COGS

If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive technology), the company is better able to charge more for it.

On the cost side, higher gross profit margin can also indicate that a company has a competitive advantage in product costs.

2. Operating Profit Margin

The formula for operating margin is…

Operating or EBITDA Margin = Operating Profit / Net Sales

Operating profit or EBITDA (earnings before interest, tax, depreciation, and amortization) is calculated as gross profit minus operating costs.

As an investor, it’s important for you to focus on a company’s operating margins, because a rising margin can lead to higher earnings growth. And there’s enough proof from the past that companies that have grown their earnings over a long many years, have created great wealth for their shareholders.

3. Net Profit Margin

The formula for net profit margin is…

Net Profit Margin = Net Profit / Net Sales

A company’s net profit margin tells you how much after-tax profit the business makes for every Rs 1 it generates in revenue or sales.

A higher a company’s net profit margin compared to its competitors, the better.

4. Return on Capital Employed

Return on total capital measures the profits a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity).

As with ROA, returns are measured prior to deducting interest on debt capital (i.e., as operating income or PBIT – profit before interest and tax). The formula is…

ROCE = PBIT / (Debt +Equity)

5. Return on Equity

Return on Equity or ROE measures the return earned by a company on its equity capital. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital). The formula is…

ROE = Net Profit / Average Equity

A business that earns a high ROE is more likely to be one that is capable of generating cash internally and thus has lesser or no need of external capital (debt) to grow its operations.

What’s a good ROE number? The minimum ROE you must target is 20%.

Since ROE depends on the equity, a company having high debt (which reduces the equity) can also end up showing high ROE. So you shouldn’t trust high ROE blindly. The debt should also be taken into consideration. Dupont analysis is one such tool to decompose ROE and evaluate if debt is skewing the ROE number.

Not all ratios are necessarily relevant to a particular analysis. The ability to select a relevant ratio or ratios to answer the research question is an analytical skill and can only be mastered with practice.

Finally, as with financial analysis in general, ratio analysis does not stop with computation; interpretation of the result is essential.

Ratio analysis is just one of the tools to look at the financial health of a company.

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