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Chapter 5 Ratio Analysis

Ratio analysis helps us understand how efficient is the company, how secure is its financial position, how profitable is it and what kind of return it generates for its stakeholders (stock and debt holders).

Types of Ratios

Efficiency ratios

These ratios help you understand how efficiently the company runs its business.

Receivable Turnover

Receivable turnover = Revenues for the period ÷ (Average of Trade Receivables at the beginning and end of the period)

A higher number indicates that the company collects its dues quickly and hence is good for its cash flows and business.

Inventory Turnover

Inventory turnover = Cost of Goods sold (COGS) ÷ (Average of Inventories at the beginning and end of the period)

A higher number indicates that the company doesn’t overstock, quickly converts inventory into sales and hence collects cash faster. For the sake of consistency, we could replace COGS with Revenues.

Payable Turnover

Payable turnover = Cost of Goods sold (COGS) ÷ (Average of Trade Payables at the beginning and end of the period)

A lower number indicates that the company is able to get long credit period from its suppliers and pays out cash slowly which is beneficial to the company. For the sake of consistency, we could replace COGS with Revenues.

Asset Turnover

Asset turnover = Revenues for the period ÷ (Average of Total Assets at the beginning and end of the period)

A higher number indicates that the company is able to generate more revenues for the value of assets on its balance sheet and hence is able to sweat its assets better than competition.

Liquidity Ratios

These ratios help you understand the ability of a company to meet it’s near term payment obligations.

Current Ratio

Current ratio = Current Assets ÷ Current Liabilities

A ratio greater than 1 means the company can easily meet its near term payment obligations.

Quick Ratio

Quick ratio = (Cash + Receivable + Current Investments) ÷ Current Liabilities

This eliminates inventories and other current assets that may not be sold immediately to raise cash. The higher the ratio, the better the company is placed to meet short term payment obligations.

Leverage Ratios

These are the best indicators of the financial health of a company. Since lenders have to be paid irrespective of the whether the company makes profits or not, these indicators show how vulnerable the company is if the economic situation turns unfavorable.

Debt to Equity

Debt Equity ratio = (Short term debt + Long term debt) ÷ Shareholder equity

A high number indicates that the company has funded most of its assets by raising debt.

Interest coverage

Interest coverage = EBITDA ÷ Interest payments

A higher number indicates that the company generates adequate profits from operations to cover the interest payment obligations. A number closer to 1 raises risk of default on interest obligations.

Profitability Ratios

These indicate how profitably the company is able to run its operations and how much return the company generates for its investors.

EBITDA margin

EBITDA margin = EBITDA ÷ Sales

This shows how profitably the company runs its operations. Company with the highest EBITDA margin among its peers has the most pricing power or the best control of costs - both are very desirable characteristics.

Net Margin

Net margin = PAT adjusted for one-off items ÷ Sales

This gives the profits attributable to the stock/shareholder after factoring in all costs including operating costs, interest payments and taxes payable to government. Again, the company with the highest net margin among peers is the most desirable.

Free Cash Flow Yield

Free cash flow yield = (Operating cash flow + Investing cash flow) ÷ (No of shares in issue * Share Price

This gives the cash return on the current value of stockholder’s equity. The higher the ratio, the more attractive is the company.

Return on Equity (ROE)

ROE = PAT ÷ Average Shareholder funds

This measures the shareholder’s return on his investment in the company.

Return on Capital Employed (ROCE)

ROCE = {EBIT * (1 – tax rate)} ÷ (Short term debt + Long term debt + Shareholder funds)

This measure the return on the total capital employed.

Valuation Ratios

The stock market offers its assessment of the value of a business. The value that it assigns to a business is called market capitalization. We have to arrive at our own estimate of the intrinsic value of a business. We then compare our estimate to that of the market’s assessment to see whether the stock is ‘undervalued’, ‘fairly valued’ or ‘overvalued’.

Market capitalization

Market capitalization = No. of shares issued * Share price

Market capitalization is the market’s assessment of the value of a company to its stockholders.

Buyout value or Enterprise Value

Enterprise value = Market capitalization + Short term debt + Long term debt – Cash & equivalents. This represents the total value of the business including the stock holder and the debt holder. Anyone willing to buy the company needs to buy all stocks and pay-off debt and then can take out cash that is left in the company.

Relative Valuation

The concept of relative valuation has two parts- (1) find the ratio between the stock’s market price and one of its financial performances metric, and (2) calculate the same ratio for all its competitors to see whether the company is cheaper or more expensive relative to its competitors.

Price/Earnings

PE Ratio= Current Price ÷ Earnings per share

This ratio indicates how much investors are willing to pay for each rupee of earnings. Companies with strong EPS growth outlook typically trade at high PE multiples whereas those with tepid or unpredictable outlook trade at lower multiples.

How do you know if a company is cheap on PE?

If a company’s PE multiple is lower than its peers and its ROE is comparable or better than its peers, it is cheap

Price Earnings/Growth

PEG ratio = PE ratio ÷ Earnings growth rate

This ratio gives the price investors are willing to pay for each percent of growth in the company’s EPS. In the case of two companies in the same industry with similar growth rates, the one with the lower PEG ratio is cheaper and hence more attractively valued.

Price/Book

PEG ratio = PE ratio ÷ Earnings growth rate

This ratio indicates how much premium/discount investors are willing to pay over the shareholder equity as per the balance sheet. Companies that generate high ROE trade at a premium to Book Value of shareholder funds while those that generate low or no ROE trade at or at a discount to Book value.

EV/EBITDA

PEG ratio = PE ratio ÷ Earnings growth rate

This is a cleaner metric than the PE ratio since it takes into consideration operating performance (and hence true profit potential) and is not influenced by a company’s depreciation policy and capital structure. So, two companies with similar EV/EBITDA multiples can have very different PE ratios if one has substantially more debt than the other. It would have much higher interest outgo and much lower PAT. So, it may look more expensive on PE but could actually be cheaper on EV/EBITDA.

Key takeaways

  • Ratio analysis helps us understand the overall efficiency of the company, its financial health and profitability.

  • Efficiency Ratio helps to understand how efficiently the company runs its business.

  • Leverage Ratios are the best indicators of the financial health of a company

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