Introduction

Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business. They are mainly used by analysts to gain insights into various aspects of a business, such as its profitability, liquidity, and solvency. Examination of relationships between financial statement numbers!

• Peer Comparison: It helps identify market gaps and examine its competitive advantages, strengths, and weaknesses. The information to formulate decisions that aim to improve the company’s position in the market.
• Trend Analysis: To see if there is a trend in financial performance. Established companies collect data from the financial statements over a large number of reporting periods. The trend obtained can be used to predict the direction of future financial performance, and also identify any expected financial turbulence that would not be possible to predict using ratios for a single reporting period.
• Operational Efficiency: To determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and building results in unnecessary expenses that ought to be eliminated

An in-depth analysis of their financial statements, like the profit and loss statement, the balance sheet, the auditor’s report, contingent liability items and so on needs to be performed. But it’s important to remember that the measures of a company’s finances are not isolated, but interconnected. That’s why these reports should not be interpreted in absolute values, but in terms of ratios or percentages, to understand how the data in these reports are connected and to form an accurate picture of the company’s overall financial status.

• Profit and loss ratios will give a measure of the scale, scope and prospects of the company’s business.
• Balance sheet ratios will identify/examine the financial strength of the business.
• Off–balance sheet items will help her understand hidden liabilities and vulnerabilities that are not visible in the company’s balance sheets.

Financial ratios lead to a better understanding of the unique nature, seasonality, competitive landscape and so on of each sector.

Can be both diagnostic (assessing current state) & prognostic (predict future state) analysis.

P & L Ratios: These ratios, also known as operating ratios, give an indication of the company’s performance for a given period.

1.  It is important to ask certain questions that will help give a contextual perspective.
2. How do these figures compare with past performance? What does the trend reveal?
3. What does the break-up of the item reveal?
4. How realistic are the Current Year Estimates?
5. Do we have the latest audited figures? Do they match with the provisional figures we got earlier?
6. What is the premise for making future projections?

1. GROWTH RATIOS

• Meaning: This ratio measures the increase in turnover or profits of a business for the year compared to the previous year(s) in percentage terms.
• Two Growth Rates: Annualized or compounded growth rates can be computed. 
• The compound annual growth rate (CAGR) is the annualized average rate of revenue growth between two given years, assuming growth takes place at an exponentially compounded rate.
• Formulas:

Annual Growth Rate = (Current Year Sales/Profit- Last Year Sales/Profit) /Last Year Sales/Profit}*100

CAGR, year X to year Z = [(Value in year Z/Value in year X) ^ (1/N)-1]

• Points to look for:

1. Fluctuations in growth rate
2. Growth rate in comparison to other companies of similar vintage, capacity and sector
3. Examine past trends and future revenue projections in cyclical industries based on the current stage of the cycle
4. Compare annual growth rates rather than on a quarterly basis, to accommodate harvest seasons in agro-commodity.
5. Allow for growth aberrations due to monsoon dependency in agro-commodity.

2. GROSS MARGIN RATIO

MEANING: Gross Margin is the difference between Cost of Goods Sold / Cost of Sales and Net Sales as a percentage of the Net Sales.

FORMULA : Gross Profit Margin = (Net Sales- COGS) /Net Sales * 100

Cost of goods sold (COGS) includes all of the costs and expenses directly related to the production of goods. COGS excludes indirect costs such as overhead and sales & marketing. 

INTERPRETATION:

1. It is an indicator of a company’s ability to pass on any input cost increase to its customers. 
2. The gross margin is a straight and direct indicator whether the actual product or service of the company is fetching a profitable price in the market. So long as this ratio is high, the core business of the company remains valuable. Erosion or decline in this ratio calls for corrective measures to be taken by the company management.
3. While calculating gross margin, finance cost, selling and administration expenses, extraordinary income and expenses are excluded.
4. Gross Margin Ratio, is thus used to check the core business viability.

Questions to be asked?

• What is the trend in raw material cost in the past & what can be expected in future?
• Is the company resorting to shoring up its revenues through trading goods or manufacturing?
• Which is the key cost driver & has it increased /decreased overtime? 
• Is the production facility taking up too much cost in repairs & maintenance ?
• Change in inventory- does it commensurate with the production & sales

3. EBIDTA MARGIN RATIO

MEANING: ‘Earnings Before Interest, Depreciation, Taxes and Amortisation’ (EBIDTA) is the most commonly used indicator in assessing a business and the strength of its core operations. 

FORMULA :

• EBIDTA Margin = EBIDTA /Net Sales * 100
• Net Sales = Gross Sales – GST
• Cost of Production (COP) = All direct costs of doing business including Depreciation
• Cost of Goods Sold (COGS) = COP + Change in Inventory
• EBIDTA = Net Sales – COGS + Depreciation- SG&A expenses

INTERPRETATION:

• It is the level of Operating Profit generated by the business during the year. The ratio denotes the Operating Margin of a company.
• It usually excludes Non Operating/ Net Other income (extraordinary income from non-core operations)- OPBDITA. Including other income, sometimes it is referred to as PBDITA
• The EBIDTA margin—is the most powerful indicator of business operations. This is where the fundamentals of the company’s business model and its strategy in the market place become visible.
• The ability to generate a good profit margin before charging depreciation and interest is therefore critical for a healthy bottom line after debt obligations.The value of EBIDTA and the EBIDTA margin should be looked at in the context of loan repayments due in the coming year.

4. NET PROFIT MARGIN RATIO

MEANING: ‘Net profit margin’ measures the net profit as a percentage of the Net Sales for a given year. It is a direct reflection of the company's profitability.

FORMULA : Net Profit Margin = Net profit /Net Sales * 100

INTERPRETATION:

• PAT is the final amount available to a company to reward its shareholders and to plough back to strengthen its net worth.
• Consistently low net profitability means the company is vulnerable to fluctuations in its income and/or expenses.
• Consistently high net profitability means the company can absorb any spikes in expenses if it is unable to pass it on to its customers in a particular year. If the spike is likely to remain unabated next year, the company may be able to re-price its products and get back to earlier level of profitability.
• Profitability stays the same but the source of profits changes every year

For example: A company shows 12 – 13% PAT level profitability continuously for last five years. But a closer look reveals that profits in two of those five years came from huge forex gains, and in another year, from the sale of some assets. Such incomes or profits are clearly not replicable every year.

• Profitability declines but the actual quantum of profits increases

For example: A company may consciously decide to price its products downwards in order to get higher market share in a booming sector. While the PAT ratio may decline, thanks to the volume gain in business, the actual net profit is high. This in turn leads to a higher plough back of funds into the business and strengthens the balance sheet.

• Profitability improves but the actual quantum of profit decreases

For example: A company’s PAT margin improves but correspondingly there is a decrease in top line revenues because the company shifts its focus from a mass market product to upper-end market product. Is vacating its core market segment and focusing on a niche product the right strategy?

5) INTEREST COVERAGE RATIO:

MEANING: ‘Interest service coverage ratio’ (ISCR) is the ability of a business to pay interest on its loans. Similar to the DSCR, ISCR is not measured in percentages, but as a fraction.

FORMULA :  EBITDA/Interest on the borrowings

INTERPRETATION:

• ISCR as a ratio is generally used to measure comfort levels in paying interest on borrowed funds. 
• From lender’s point of view, a high ratio provides reasonable assurance that the company is comfortable in servicing its interest servicing. Failure to service interest obligations can render an account NPA.
• It assumes a greater significance where term borrowings are low but working capital borrowings are high.
•  In other cases, ISCR would usually be viewed secondary to DSCR. Normally, ISCR for any single year should not be less 1.75 and Average ISCR should not be below 2.00

BALANCE SHEET RATIOS

A balance sheet is considered “Mother of all the financial statements”  and depicts what are the sources & the uses of funds. It is a listing of Assets & the sources of funding these assets  i.e. the liabilities

• Liquidity Ratios: Current ratio & Quick ratio
• Leverage Ratios: TOL/TNW, Total Debt /TNW , Long Term Debt/ TNW

We need to analyse the relationship between the company’s assets and liabilities to see what kind of changes are occurring in the company’s capital structure and gauge its strengths and weaknesses.

Capital/Funds can be both equity and debt capital. The changes in this structure inter-se or by way of an increase or decrease results in corresponding changes elsewhere within the balance sheet. The impact of these changes on the balance sheet ratios and the analysis of its strength could be significant.

1. CURRENT RATIO:

MEANING: 'Liquidity ratio or Current ratio’ represents the assets that are available to be liquidated at short notice, if funds are required for immediate, short-term payments. 

FORMULA : Current Ratio=  Current Assets/Current Liabilities

• Current Assets : All the assets of a company that are expected to be sold or used as a result of standard business operations over the next year. Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, and other liquid assets.
• Current liabilities are a company's debts or obligations that are due to be paid to creditors within one year.

INTERPRETATION: If current assets (numerator) are higher than short-term liabilities (denominator), the company is said to have a ‘liquid surplus’ available. 

• Current Ratio > 1.00 only if Long term sources (TNW+LT Debt) > Long term uses (Net Fixed assets+ Investments). OR NWC is positive: This means that long term sources, after funding the long term uses, are also funding part of the working capital; implying a comfortable liquidity position over the next one year.
• Current Ratio  < 1.00 only if Long term uses (Net Fixed assets+ Investments) > Long Term sources (TNW+LT Debt) OR NWC is negative: This means that long term assets have been funded from short term funds/liabilities. While the liabilities will fall due for repayment, the corresponding assets are unlikely to fall due in near future causing strained liquidity.

Points to be noted:

• Current assets can often get inflated due to ‘Other Current Assets’ that may not be core to the operations of the company. 
• One of the most common factors causing the liquidity ratio to fall is the accounting treatment of Term Debt falling due for repayment in the next year. 
• Funds placed in fixed deposits with banks as security for off-balance sheet liabilities also need to be considered.
• Value of the Current Ratio is NOT an indicator of the quality of the assets/liabilities.
• Higher the ratio, better is the liquidity. But a very high CR> 2.00 may not add value to the company’s credit quality.

2. QUICK RATIO

 MEANING: The acid-test ratio disregards current assets that are difficult to liquidate quickly such as inventory.

FORMULA: Quick Ratio=  (Current Assets- Stock –Prepaid expenses )/Current Liabilities

INTERPRETATION:

Higher the ratio, the better it is. A ratio of 2 times implies that the company owns Rs 2 of liquid assets to cover each Re 1 of current liabilities.

• The acid-test ratio is used to indicate a company’s ability to pay off its current liabilities without relying on the sale of inventory or on obtaining additional financing. Inventory is not included in calculating the ratio, as it is not ordinarily an asset that can be easily and quickly converted into cash. 
• Compared to the current ratio – a liquidity or debt ratio which does include inventory value in the calculation – the acid-test ratio is considered a more conservative estimation of a company’s financial health.
• It may not give a reliable picture if the company has accounts receivable that take longer than usual to collect .The ratio excludes inventory & prepaid expenses as is not generally considered a liquid asset. However, some businesses are able to quickly sell their inventory at a fair market price.

 Leverage ratios:

A company’s capital structure--commonly referred to as its gearing, leverage, or debt-to-equity ratio--reflects the extent of borrowed funds in the company’s funding mix. 

The equity component in the capital employed by a company has no fixed repayment obligations; returns to equity shareholders depend on the profits made by the company.

Debt, on the other hand, carries specified contractual obligations of interest and principal. These will necessarily have to be honoured, in full, and on time; irrespective of the volatility witnessed in the business. 

 3. TOTAL DEBT/TNW

MEANING: ‘Gearing ratio’ looks at the extent to which a business entity has used its ‘equity capital’ to create the ‘total capital structure’ that supports the balance sheet.

FORMULA : 

Total Debt/TNW =  Total Debt/Tangible Networth (TNW)

= (Long Term Debt + Short Term Debt)/ TNW

INTERPRETATION:

• The ‘Total Debt’ includes short-term debt such as Working Capital Borrowings for this purpose. It also includes installments of term loan due within 1 year.
• Funds infused into the company by promoters by way of unsecured loans, debentures, convertible equity instruments, preference shares and so on are considered as Quasi-Equity or own funds.
• A company’s net worth is a reflection of its size. A large net worth usually reflects the company’s strong market position and economies of scale; it also enhances financial flexibility, including the company’s ability to access capital markets.
• A strongly capitalized company will thus be more resilient to economic downturns
• There is also a concept of Adjusted Tangible Net Worth (ATNW): Investments in and loans to subsidiary/group entities are reduced from the TNW, since these funds are not available to the company for its own business.

 4. LONG TERM DEBT/TNW

MEANING: ‘Debt-Equity ratio’ (DER) is an indicator of the promoter contribution towards a new project or purchase of a new asset. When a new project is undertaken, it is usually financed through a mix of loans and investment. The investment component is generally through equity or equity-like structures, while the loans could be in the form of debt structures.

FORMULA : Long term Debt/Tangible Networth (TNW)

INTERPRETATION:

• As with gearing ratio, unsecured loans from promoters, compulsorily convertible debentures, debentures, convertible equity instruments, preference shares and so on are considered as Quasi-Equity.
• Deferred Tax Liability is considered as own funds, and the Tangible Net Worth is adjusted for investments in and loans to subsidiary/group entities.
• Depending on the project, vintage of the company, the asset being purchased and so on, the lenders may seek an ideal DER of 75:25 or better.

 5. TOL/TNW

MEANING: Leverage ratio represents the extent to which a business entity is dependent on outside funds in relation to its own internal corpus. This may also be considered as the Total Indebtedness Ratio.

FORMULA : TOL/Tangible Networth (TNW)

Total Outside Liability (TOL) = Short Term Liabilities  + Long Term Liabilities

Tangible Net Worth (TNW) = Paid up Capital + Share Premium + Accumulated Profits – Losses Not Written Off- Intangible assets

INTERPRETATION:

• Borrowed funds include not just loans, but also unpaid creditors, unpaid dues and provisions for future outflow of funds.
• Own funds refer not just to the original investment made by the promoters, but also accumulated profits of earlier years.
• Thus, the ratio reflects contribution of shareholders in supporting the assets of the company and overall financial strength of the company.

COMBINED STATEMENT RATIOS

1. DSCR

MEANING: ‘Debt service coverage’ ratio (DSCR) is the ability of a business to repay its loans, as well as the interest on those loans. DSCR is not measured in percentages, but as a fraction.

FORMULA:  PAT+ Depreciation +Interest (usually TL)/ (Loan repayments due within 1 year + Interest on the loan)

• PAT +Depreciation is also called Net Cash Accruals.

• Debt payable within one year (CPLTD) primarily constitutes the present portion of long-term debt (the portion of a long-term debt that is slated to mature during the ongoing year)

INTERPRETATION:

• DSCR is to be calculated for each year of the loan tenure including the moratorium period where interest is payable.
• As in other ratios/indicators, the DSCR may get distorted due to effect of extraordinary items and change in composition of cost components. Hence, DSCR should also be seen in conjunction with EBIDTA and gross margin.
• A higher ratio implies that the entity is more creditworthy because they have sufficient funds to service their debt obligations – to make the required payments on a timely basis.

Other aspects of DSCR;

• One of the fundamental principles of any term loan repayment structure is that the loan availed for buying any fixed asset should get repaid at a pace faster than the rate at which the fixed asset depreciates. A thumb rule is the loan duration should not exceed 85% of the economic life of an asset. 
• An average DSCR for the entire loan tenure is also calculated.
• Normally, DSCR for any single year should not be less than 1.10-1.20 and the average DSCR ideally should be above 1.25-1.50.
• Two adjustments that are usually done in computation of DSCR:

1. DSCR net of accruals committed for capex as the same will not be available for debt servicing
2. Computing Cash DSCR: wherein it is expected that 25% of the Incremental Net Working Capital will come from the net cash accruals. 

DSCR is most commonly used ratio in case of Project financing or Term Loan assessment. DSCR Sensitivity is also commonly used to assess the impact of changes in key factors on DSCR.

2. ROCE

MEANING: ‘Return on capital employed’ (RoCE) refers to the returns generated by a company on the total debt and equity capital it has deployed.

FORMULA   

ROCE = PBIT / Capital Employed

Capital Employed = TNW + Total Debt

PBIT = Profit Before Interest and Tax

INTERPRETATION:

It measures how efficiently a company is using its capital to generate profits. The return on capital employed metric is considered one of the best profitability ratios and is commonly used by investors to determine whether a company is suitable to invest in or not.

Example: Apple Inc has ROCE of 23% in 2017. This means for every 1$ invested in the company, it generates an income of 23$.

• RoCE indicates management efficiency.
• It is independent of leveraging because it considers the total capital employed.
• Determine the benchmark ROCE of the industry. For example, a company with a ROCE of 20% may look good compared to a company with a ROCE of 10%. However, if the industry benchmark is 35%, both companies are considered to have a poor ROCE.

WORKING CAPITAL CYCLE:

A business uses its working capital to meet its day-to-day operations. What exactly is working capital? 

It is that portion of the total capital of a business that is invested in the current assets. It is also called as revolving or circulating capital as the money invested circulates in various forms of current assets in a continued manner.

• At a point in time, funds may be invested in raw materials, then converted into semi-finished products, and then into finished products.
• When these finished products are sold, the funds are converted into accounts receivables or cash. This cash is reinvested into current assets and the cycle goes on.
• All these current assets comprise the investment that the working capital covers in which, the cash invested returns as cash after going through the various stages.
• Gross Operating cycle: Debtors holding period + Inventory holding period

TURNOVER RATIOS

1. Debtors Turnover Ratio

MEANING: The ‘debtors to sales ratio’ determines how many times Sales Receivables outstanding as book debts are collected during one business cycle. Also called Debtor’s Velocity- how fast debtors converted to cash

FORMULA :  Net Credit Sales /Average Debtors Outstanding

Average debtors= (Opening debtors + closing debtors)/2

INTERPRETATION: 

• Higher the ratio the better it is.
• The ideal ratio is considered to be 6 (which is equivalent to 60 days), but it may vary depending on the nature of business. A value of 6 or higher means sales made on edit terms are quickly collected and ploughed back into the working capital cycle.
• Year-end Book Debts Outstanding may be a misleading position or aberration. In capital goods manufacturing, often sales are booked in the last quarter. Some seasonal businesses may also have sales invoicing skewed towards year end. A 12-month average of Book Debts outstanding should be used.

2. Creditors Turnover Ratio

MEANING: The ‘credit turnover ratio’ indicates the speed at which payments are made to trade creditors for raw materials, as well as the continuity in raw material availability. Also called creditors velocity

FORMULA : Net Credit Purchases/Average Trade creditors Outstanding

Net Credit Purchases = Credit Purchases- Purchase return

Average trade creditors =(Opening trade creditors/bills payable+closing trade creditors/bills payable)/2

INTERPRETATION: 

• A high ratio indicates a longer payment period
• A low ratio indicates a shorter payment period
• The ideal ratio is considered to be 10 (which is equivalent to 30 days), but it may vary depending on the nature of business. A value of 10 or higher means purchases made on credit terms are quickly settled and continuity in raw material availability is assured. It also indicates there are no liquidity or cash flow issues in the company.
• Net Purchases made on credit may not always be available. Hence, Total Purchases during the year as per P&L can also be used.
• Year-end Trade creditors outstanding may be a misleading position or aberration. Some seasonal businesses may have procurements skewed towards the year end. Hence, average is used.

3. Inventory Turnover Ratio

MEANING: The ‘Stock turnover ratio’ is an indicator of how quickly the stocks are processed and converted into sales. It is also known as the ‘Inventory turnover ratio’. Establishes the relationship between Cost of goods sold and inventory.

FORMULA : COGS /Average Inventory

COGS= Opening stock+ Purchases+ Direct expenses-Closing stock

COGS= Sales – Gross Profit OR  Sales + Gross Loss

INTERPRETATION: 

• The ideal value of this ratio is considered to be 10 (which is equivalent to 30 days) but it may vary depending on the nature of business. A value of 10 or higher means working capital is not blocked in inventory in the form of excess raw material or unsold goods. It shows that processing is efficient, sales are steady and working capital funds are being used optimally.
• Year-end Inventory holding may be a misleading position or aberration. Some seasonal businesses may have procurements skewed towards year end.
• Hence, an average of the opening and the closing stock is generally used.

4. Fixed Assets Turnover Ratio

MEANING: Fixed Asset Turnover (FAT) is an efficiency ratio that indicates how well or efficiently a business uses fixed assets to generate sales. It establishes the relationship between the : Net sales & Fixed Assets

FORMULA : Net Sales/Average Fixed Assets

INTERPRETATION: 

• This ratio divides net sales by net fixed assets, calculated over an annual period. The net fixed assets include the amount of property, plant, and equipment, less the accumulated depreciation. 
• Indicates the firm’s ability to generate sales per rupee of investment in fixed assets.
• Generally, a higher fixed asset ratio implies more effective utilization of investments in fixed assets to generate revenue. This ratio is often analyzed alongside leverage and profitability ratios.
• When the business is underperforming (in terms of revenues) and has a relatively high amount of investment in fixed assets, the FAT ratio may be low.
• This is especially true for manufacturing businesses that utilize big machines and facilities. If the company recently incurred a huge capex, the low FAT may be distorted.
• A declining ratio may also suggest that the company is over-investing in its fixed assets.

OTHER ASPECTS TO EXAMINE:

• Cash & Bank balances to the debt of the company or The NET DEBT levels
• Auditor’s Notes – For any adverse comments
• Statutory payments overdue
• Disqualification of any director
• Pledge of shares
• Any adverse qualification wrt the going concern
• Contingent Liabilities
• Related Party Transactions (RPT)
• Cases filed against the company/Litigations

LIMITATIONS OF RATIO ANALYSIS

• Historical Information- too much weight on past 
• Change in accounting policies/aware of the differences in accounting standards
• Looking beyond financial information-Operational changes or management changes
• Window dressing/Creative accounting

By Sonali Mahajan