November 2, 2000

Financial Ratios - An introduction

In one of our earlier School chapters, we had written about how to read a Balance Sheet. In that we had touched upon ratio analysis in a brief way. In this chapter, we will go into the topic in some detail.

Financial ratios are more than just simple arithmetic. But, yes, numbers are important as any kind of Financial Analysis starts with numbers. But it certainly does not end there. So let's begin from the beginning.

What is a ratio?

A ratio is nothing more than a simple division of two numbers. Often numbers by themselves do not convey anything until they are related. It needs a contextual reference.

In our day-to-day life, we use ratios to analyze a variety of situations. For instance, in a one-day cricket match if somebody tells you that India has to make 70 runs to win the match, it means nothing. If somebody tells that India needs 70 runs in 10 overs, it is a more useful piece of information. You know that the asking rate is 7 runs per over. But is that enough. There are some more interesting questions that would come to one's mind. Such as how many wickets are remaining? Is our star batsman Sachin Tendulkar still batting? How many of the 10 overs remaining will be bowled by Saqlain Mushtaq? Is the pitch playing true? And so on.

Similarly, in financial analysis, we need qualitative information and try to read between the numbers. We have to ask all the right questions. Over the years, there are some ratios, which have become more popular and handy for rule of thumb analysis of financial statements. Our purpose should be to use them properly in order to derive the correct results.

How not to use ratios?

In order to know how to use a ratio, let's check how not to use one. Let's take an example and understand how a ratio by itself can be misleading. Take an instance of a fast growing software company for which receivables as percentage of sales increased from 25% last year to 50% this year. Is it bad? Many pundits would immediately decree that the company's working capital management is poor, accounts receivables are high, company will have cash problems, interests on working capital will go up, etc etc…

Nobody dislikes businesses, which are growing very fast. It is quite likely that the sales towards the end of the year would be far greater than the average for the full year and receivables as a percentage of sales calculated on the basis of total year would be misleading. The company's receivables appear higher for this reason. In other words, suppose sales for the full year was Rs100, of which last quarter sales was Rs50. A three-month credit period would result in receivables of Rs50 i.e. 50% of annual sales or equivalent to 6 months sales. In reality, they are only for 3 months sales. Also some businesses are seasonal. Nestle has to stock up in winter for its milk as well as coffee beans. These are critical raw materials and available in abundance only in winter, but used throughout the year. So if the year-end is in December, the actual working capital figure will be significantly higher than the average for the year.

Key objectives of a business

Before you look at different ratios, let us look at a firm's objectives in a capitalist market. While businesses claim to have multiple objectives such as gaining market share, promoting quality products and even social objectives, at the end of the day, what really matters is how much money one makes. All are strategies to maximize return on capital employed, which is the one and only long-term goal of all management.

Obviously one will look at money made in relation to one's investment. If you use 10 times as much capital and make 5 times more money, it is of no good. If business A earns Rs10 on Rs100 investment (10%), it is better than another business B that earns Rs50 on Rs1000 (5%).

To analyze the performance of any business, the key ratio is therefore Return on Capital Employed (ROCE). We can further analyze this ratio using a model popularly know as the Du Pont model.

The model starts with an analysis of the ROCE in its two constituents

To give an example, say business A is one in which Rs100 capital invested in a year generates sales of Rs100 with net profit margin of 10%. In business B, a Rs100 investment generates a turnover of Rs500 but with a net profit margin of only 4%.

As you can see, in business B, net profit margin can be lower but is more than compensated by the fact that turnover generated per unit of capital invested is significantly higher or capital turnover ratio is higher. Return on capital invested is the product of sales margin and capital turnover ratio. The same can be presented in the formula as follows.

(Net profit / sales) * (sales / capital employed) = Return on capital employed

Abhijeet Dey