Financial Ratios

As a child I was always very competitive and the easiest way for me to judge my performance was my exam scorecard. Every semester, we would have an ‘Open House’ in our school where are teachers would discuss with our parents, are weak points and highlight areas we need to improve. This would help are parents to in turn make us understand and motivate us to improve. As we grow and grow in our career, we understand the importance of being competitive but now the score card is not based on some three hour answer sheet but now we are judged at every aspect of our work. Similarly even when we look at any company for investment, we look at their annual reports for detailed results and listen to the management for more focused understanding on areas where the company would improve and grow.

A simple way to study any company report would be its financial statements. Although it might look complex as they need to adhere to various accounting standards laid by the ICAI, at the end of it is nothing but a tallied record of last one year of all your income-expenses, assets and loans. Any accounting student would be well aware of the concept of final accounts, where all the books are tallied and the actual business financial holding is derived. Learning the impact of all the entries in books of accounts would be difficult for any investor before making any investment. Hence we can read the financial statements in a much simpler way by calculating some basic financial ratios which gives us a rough idea of the performance of the company. 

All the listed companies are mandated to follow the IAS – Indian Accounting Standards to declare the results (format given out in Companies Act), which are supervised by SEBI. A quarterly result usually consists of the following elements:

a)   Profit & loss Statement.

b)   Balance Sheet as on date

c)   Cash Flow statement.

The above three statements are more or else sufficient to judge, the working of company. However, for a better understanding of long term projects and utilization one should look at yearly annual reports. 

What do we study in these given statements?

Some of the things that we should study closely in order to adjudge a company’s growth against the industry benchmarks are:-

     a)  Profit Ratios

1.   Operating Profit – it is ratio defining the percentage of sales to gross profits. (i.e. profit derived before interest and depreciation but after deducting the manufacturing expenses.)

2.   Net Profit – it is also known as distributable profit to the shareholders of company. It mirrors the capacity to fund its own future projects. It is defined as percentage of gross sales to net profit after deducting interest and depreciation.

3.   Return on Equity- it is defined as return earned by shareholder for every rupee invested by him in the company. It is computed by dividing the net profit with the total shareholders’ equity.

     b)  Liquidity Ratio

1. Current Ratio – it is a ratio that defined whether the company in short term is well covered to repay all its near term debt with its liquid or marketable assets. It is defined as current assets divided by current liabilities.

     c)   Debt Management Ratios

1. Debt to equity ratio – it is a simple calculation to understand if the people who have invested or own the business really have control over the company or is it completely burdened by third party decisions. If the third parties have a higher stake in the company it might be a good preposition to invest in sinking boat. It is ratio of total shareholders fund to long term creditors.

     d)  Asset Management Ratios

1.  Return on Assets – the purpose of this ratio is to understand whether the capital assets investments are being utilized to its fullest capacity or are they lying idle. It is measured by dividing the net income with the total long term assets. It also shows whether the capital expenditure projections are in line of growth or inappropriate.

2.  Inventory turnover- it shows whether the company is planning right its projects or is it blocking the company funds in wrong way. High inventory could lead to other allied recurring expenses which ultimately do not add up to sales.

     e)  Market value ratios

1. Price to Earnings Ratio – this is one of most popular ratio as it describes the investors’ sentiment based on his understanding of company growth. It is measured as current price over its anticipated future performance. If its’ P/E is below the industry standard, the stock still has chances to grow.

2. Price to Sales Ratio - it is a simple math of what is the ratio of total sales over its current market capital. It describes the price sale unit performance for the price being paid.   

Application of above ratios

Some of the commonly used ratios to evaluate any company are as follows: 

Industry	Ratios
Manufacturing	Debt – Equity , Operating profit margins, Asset utilization, Inventory turnover
Information Technology	Revenue mix- Domestic /export break up , operating margins – employee cost, Asset utilization, cash flow investment
Banking /Financial Institutions	Loan book, Interest coverage ratio, debt turnover ratio
FMCG	Current ratio, Inventory turnover, Working capital cycle, debtors turnover, Price to Sales, Segment revenue and mix