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
|
