Analysis of a company involves a thorough assessment of the factors that affect its business and the underlying growth drivers. It is an endeavor to understand a host of factors that affect the company’s fortunes.
Is the company’s revenue growing?
Is it actually making a profit?
Has it got strengths, which it can leverage in order to march ahead of competition in the near future?
Is it able to repay its debts timely?
Is the management resorting to ‘window dressing’ of its financials?
One technique to answer the above questions is through ratio analysis of the company’s financial statements. Ratio analysis is a quantitative technique to identify the relationship between its performance indicators as set out in the following: Balance Sheet, Profit & Loss Account and Cash Flow Statement. An analyst can compare the present ratios of a company with its historical (or expected) ratios or with those of competitors / industry averages.
The ratio could be categorized under the following groups:
Liquidity Ratios
Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations.
In general, if liquid assets cover the short-term liabilities adequately, one may infer that not only will it will be able to pay off its debts that would come due for payment in the short term but also manage to fund its ongoing operations.
1.1 Current Ratio
Current Assets
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Current Liabilities
Current Assets include cash, marketable securities, debtors, inventory, loans & advances and prepaid expenses. Current Liabilities include trade creditors, provisions and accrued expenses.
In the operating cycle of the company, current assets are converted into cash to provide funds for payment of current liabilities. So the higher this particular ratio, the better is its short-term liquidity position.
However, one must also analyze the composition of current assets. A company with a higher amount of cash and accounts receivable is more liquid as compared to that with a high amount of inventories in its current assets, though both might be having the same current ratio.
The following example highlights the fact that one should not rely solely on current ratio or working capital to assess a company’s liquidity position.
Company ABC has Current Assets Rs 600 and Current Liabilities Rs 300
Company XYZ has Current Assets Rs 300 and Current Liabilities Rs 300
Prima facie it may appear that Company ABC is better placed in terms of liquidity and has a safe current asset/liability margin (current ratio of 2:1 and working capital of Rs. 300).
However, consider the following scenario:
Both companies' current liabilities have an average payment period of 30 days
Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days)
Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days)
Thus Company ABC is rather illiquid and would not be able to operate under the conditions enumerated above.
A current ratio of 2:1 is generally considered as a benchmark. However analyzing the trends in the company’s cash conversion cycle along with its current ratio would facilitate a better understanding of its liquidity position.
1.2 Quick Ratio
Quick Assets
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Quick Liabilities
Quick Assets is Current Assets-Inventory- Prepaid Expenses.
Quick Liabilities is Current Liabilities-Bank O/D
Quick Ratio represents a more stringent measure of a company’s liquidity position. Inventory is excluded from the computation as it has to go through a two-step process of first being sold and converted into receivables and secondly the receivables being actually collected when due for payment. Prepaid Expenses are also generally not convertible into cash and hence not considered as quick assets.
Another possible comparison could be that of a company’s current ratio with its quick ratio. If the current ratio were significantly higher vis-Ã -vis the quick ratio, it would indicate the relative concentration of inventory in the current assets.
1.3 Cash Ratio
Cash +Cash Equivalents+ Invested Funds
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Current Liabilities
Cash Ratio considers only the most liquid short-term assets of the company, which can be most easily used to pay off current obligations. It ignores inventory and receivables, as there is no firm assurance that these two accounts can be converted to cash in a timely manner to meet current liabilities.
Most companies would rather not be having enough cash and cash equivalents to fully cover their current liabilities. Consequently they would be having their cash ratio as below 1:1. It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. This is because surplus cash on its balance sheet would be viewed as an indicator of poor asset utilization (This money could either be returned to shareholders or used elsewhere to generate higher returns).
Although cash ratio presents liquidity from an interesting perspective, its usefulness is quite limited and analysts seldom it for while studying the company’s fundamental analysis.
1.4 Bank Finance to Working Capital Gap Ratio
Short-term bank borrowings
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Current Assets less Current Liabilities (excl. bank borrowings)
This ratio indicates the degree of the company’s reliance on short-term bank finance to bridge the existing working capital gap.
2.Profitability Ratios
Long-term profitability is vital for a company, both from the perspective of survival as well as shareholder return on investment.
2.1 Profit Margin Analysis
It is the quality and growth of a company’s earnings that largely determines its valuation.
Instead of viewing absolute numbers in the income statement in isolation, we must use margin analysis to discern a company's true profitability. A large growth in sales may not translate in higher earnings if costs and expenses grow disproportionately.
2.1.1 Gross Profit Margin
Gross Profit
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Net Sales
This ratio analyses how efficiently a company has used its raw materials, labour and manufacturing related fixed assets.
Generally management cannot exercise complete control over raw material costs as these are strongly influenced by industry-wise trends. However it may have an effective strategy in place, which partly offsets the impact of short-term price fluctuations. For e.g. a paper company may engage in farm forestry/social forestry programmes to partly insulate itself from volatility in wood & pulp prices. A steel producer may be having control over captive iron-ore and coal mines. The impact of these arrangements would be reflected in their gross profit margin trends.
Further, companies without a production process (e.g. retailers and IT companies) do not really have a cost of sales. In these cases, the expense is recorded as ‘cost of merchandise’ or ‘cost of services’. The gross profit margin in such companies does not carry the same weight as a manufacturing company.
2.1.2 PBDIT Margin
PBDIT
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Net Sales
The operating profit amount is obtained by subtracting a company's selling, general and administrative (SG&A) expenses from its gross profit amount. Management has a greater control over operating expenses than the cost of sales. PBDIT assesses profitability without considering the impact of depreciation, which is more in the nature of an accounting charge. Interest costs are also excluded from the computation as operational results are computed from the viewpoint of the providers of long-term funds.
Positive/negative trends in this ratio are therefore indicative of the efficiency/inefficiency of the management’s decision-making process. Thus PBDIT margins are often preferred in investment analysts for making financial projections and inter-company comparisons.
2.1.3 PBT Margin
PBT
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Net Sales
Effective tax rates vary across companies on account of tax management techniques being practiced/fiscal incentives being availed by management to influence the timing and magnitude of its taxable income. This may act as a constraint in peer group comparison as well as year-on-year comparisons within the same company. Thus, from a quality of earnings perspective, one would prefer PBT margins for which its operational managers of a company are more responsible than its tax accountants
2.1.4 PAT Margin
PAT
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Net Sales
The so-called bottom line is the most-often discussed metric when discussing a company’s profitability. This ratio shows the earnings available for shareholders, both equity and preference. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management functions in the company.
2.2 Return on Assets (ROA)
PAT
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Average Total Assets
This ratio measures the profitability of a company in relation to its total assets. Thus it is an indicator of the efficiency with which management is utilizing the asset base to earn returns for stakeholders.
Capital-intensive businesses, with a large investment in fixed assets, carry a relatively large asset base as compared to technology/service businesses. Consequently while making peer comparision, one must select companies while are not only in the same industry but also similar in terms of product line and business type.
2.3 Return on Equity (ROE)
PAT-Preference Dividend
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Average Net Worth
ROE indicates the profitability of equity funds invested in the business. Peer-company, industry and overall market comparisions are appropriate with this ratio.
A highly leveraged company with a modest equity base would generate a very high ROE. Thus the ROE metric needs to be viewed in the context of the company’s debt-equity relationship and average cost of debts funds in order to gain a better understanding of its profitability.
2.4 Return on Capital Employed (ROCE)
PBIT
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Capital Employed
Capital Employed is the sum of Average Debt Liabilities and Average Shareholders’ Equity
Since ROCE compares profits with the sum of a company’s debt and equity capital, it enables an investor to gauge the impact of financial leverage on its profitability. By considering debt also into the computation, it comprehensively measures the management’s ability to generate earnings from the available capital base.
As a general rule of thumb, ROCE should be greater than/equal to the company’s weighted average cost of capital (WACC).
3.Capital Structure Ratios
Capital Structure ratios are used for the following purposes:
Measuring the degree of risk resulting from debt financing. The higher the debt component in the capital structure of a company, greater is the likelihood that debt servicing would consume a large portion of its earnings. This would leave the company with lesser quantum of funds for re-deployment into the business and thus long-term earnings prospects could be adversely affected.
Forecasting borrowing prospects in terms of the ability to take on additional debt in cases where the company is considering expansion and needs to raise additional funds.
3.1 Debt-Asset Ratio
Debt
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Assets
Generally the debt component includes all liabilities including current.
Debt-Asset Ratio measures the extent to which borrowed funds support the company’s assets. The higher the ratio, the more leveraged it is and the riskier it is considered to be.
The use of leverage as displayed by this ratio, can be a double-edged sword for companies. The strategy is advantageous if they manage to generate returns above their cost of capital.
However, one may note that debt-asset ratio takes into account operational liabilities also (such as accounts payable and taxes payable). Companies, as going concerns, use operational liabilities to fund their day-to-day operations and thus they do not constitute ‘debt’ in the leverage sense of this ratio. This to a certain extent limits the usefulness of this ratio.
3.2 Debt-Equity Ratio
Debt
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Equity
Generally the debt component includes all liabilities including current. The equity component consists of net worth and preference capital.
Debt-Equity ratio provides another vantage point on a company’s leverage position. Generally large and well-established companies are in position to take a higher debt component on their balance sheets without getting into trouble.
One of the limitations of the debt-equity ratio is that its computation is based on book value. It is sometimes useful to calculate these ratios using market values. At the time of a mergers and acquisitions or corporate restructuring, the value of equity and debt will be affected by the basis of computation. For e.g. consider a sick company which owns a large property bank and whose equity is initially computed at book value. It could possibly turn out to be a healthy one if its assets are valued at market prices instead.
If the analysis reveals that debt constitutes a significant part of the total capitalization, one needs to investigate further into the company’s financial position, result of operations and its future prospects.
3.3 EBITDA/Interest Coverage Ratio
EBITDA
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Interest Payments
The ratio assesses a company’s financial durability by examining whether it is at least profitable enough to meet its interest expenses.
Consider a scenario where a company needs to spend a large portion of its profits for the replacement of its old & worn out equipment. Since EBITDA does not consider depreciation related expenses, the ratio may not be a definite indicator of financial durability.
3.4 Cash Flow / Debt Ratio
Operating Cash Flow
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Debt
Debt is taken as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. A more conservative view would be to use a company’s free cash flow (operating cash flow minus the amount of cash used for capital expenditure) in the numerator.
This ratio indicates the company’s ability to cover total debt with its yearly cash flow from operations. The higher the percentage of this ratio, the greater would be its financial strength. On the other hand, a low percentage ratio could be a negative sign, which indicates either excess debt on the company’s balance sheet or weak cash flow generation. It is important to investigate the reason behind a low ratio. To do this, one may compare the company's current cash flow to debt ratio to its historic level in order to identify trends or early warning signs.
4. Operating Performance
These ratios give us an insight into the efficiency with which a company’s assets are being used to generate revenue and increase shareholder value.
4.1 Asset Turnover Ratio
Sales
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Capital Employed
The asset turnover ratio reflects a company’s efficiency in leveraging its asset base to generate revenue.
Idle/underutilized assets necessitate costly financing and also incurrence of repair & maintenance expenditure. The strategy of achieving a higher turnover on the same asset base reduces costs and eventually yields higher profits for shareholders.
It also indicates pricing strategy. Companies with low profit margins tend to have higher asset turnover while those with high profit margins have low asset turnover.
There is no standard benchmark for asset turnover ratio. Investment in fixed assets would vary in line with the industry in which a particular company operates. For e.g. asset-turnover ratio for the FMCG industry will be quite higher than for capital intensive industries like paper/hotel.
4.2 Sales / Revenue Per Employee
Sales / Revenue
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Number of Employees (Average)
As a gauge of personnel productivity, this indicator simply measures the amount of sales or revenue generated per employee. Industry and product-line characteristics will influence this metric. Labour-intensive businesses (e.g. mass market retailers) will be less productive in terms of their revenue per employee as compared to a high-tech IT player or high product-value manufacturer. Tracking this figure historically and comparing it to peer-group companies will make this metric more meaningful for analysis purposes.
4.3 Debtors Turnover Ratio
Credit Sales
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Average Accounts Receivable
This ratio indicates the number of times on an average the receivables are generated and collected during the year. Higher the debtors turnover ratio, greater is the liquidity of the company.
If the average collection period is found to be consistently higher than the net credit period extended by the company to its customers, then the collection effort has to be made more effective as cash is locked up for a period more than what is justified and thus leads to an opportunity loss. Further, the longer the company has its money remaining uncollected, the higher is the risk it is bearing. One needs to assess whether or not it is having a tight control over the collection function. Alternatively, it could so happen that in a bid to garner a higher market share, it is offering easier payment terms to customers.
4.4 Inventory Turnover Ratio
Cost of Goods Sold
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Average Inventory
One may also come across another definition for this ratio, which is computed by dividing sales by the average inventory. This however has an inherent anomaly in that while the numerator i.e. sales includes profit, the denominator is considered at cost as per the prevalent accounting practices. And thus it is better to consider cost of goods sold which is devoid of the profit element.
This ratio indicates the efficiency of the inventory management function in the company. However, caution is needed, as a very high turnover may be indicative of over-trading.
It could also be used to measure whether an optimum quantity of goods are available for sale when compared to the actual sales orders. Minimal inventory levels might mean that a company cannot fulfil orders on a timely basis, thereby resulting in lost contribution on sales. Simultaneously, the company also runs the risk of incurring excessive inventory holding costs.
The nature of the business also needs to be taken into account before commenting upon the appropriateness of the size of inventory in a particular company. Consider a scenario where an Indian manufacturer is importing a key raw material from the USA. Its strategy of carrying a high inventory of raw material is justified if the rupee has been constantly depreciating against the dollar. Thus the situation involves a trade-off between the possible forex fluctuation losses and the storage costs being incurred.
One may arrive at a more meaningful conclusion about inventory turnover if he analyses the its composition, its change over the years and industry-wise trends. Studying the composition is important because this ratio computed on inventory as a whole may be not bring to light certain important details.
Consider a scenario where Class A comprising of only four product items constitutes 40 % of the company’s sales and account for only 10 %% of the inventory cost. Thus these fast-moving items have a turnover ratio of 20 ($ 2,000/ $ 100). And therefore the majority of the items in Class B are turning on an average of 110 days, a significant deviation from the overall average of 73 days.
5. Operating Performance
Cash Flow indicators focus on the cash being generated in terms of how much is being generated and the safety net that it provides to the company. No doubt profits are quite important and are thus the most widely discussed metric for analysis. If we negate the impact of accounting jugglery and non-cash-based transactions, companies that appear very profitable may actually be at a financial risk if they are generating little cash from these profits. Consider a scenario where a company hasn't actually received payment from its debtors for the sales generated during the year. Thus in spite of the profits made, its financial health may be adversely impacted because it has no funds to meet its obligations to creditors.
5.1 Operating Cash Flow/ Sales Ratio
Operating Cash Flow
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Sales
It would be a matter of concern if a company's operating cash flow has not grown in line with its sales growth. Positive and negative changes in a company's terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.
Higher the amount of operating cash flow, the better it is. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent and/or improving percentage comparisons are positive investment qualities.
5.2 Free Cash Flow/Operating Cash Ratio
Free Cash Flow
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Operating Cash Flow
Free cash flow is most often defined as operating cash flow minus capital expenditure during the year. Capex is generally considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency. The cash flow remaining after this deduction is considered "free" cash flow, which becomes available to a company to use for expansion, acquisitions and/or financial stability to weather difficult market conditions.
The higher the percentage of free cash flow embedded in a company's operating cash flow, the greater is its financial strength.
Another variant of the above computation would be adding the payment of cash dividends to the amount for capital expenditure in the numerator. This would be providing a more conservative free cash flow number. According to many analysts, the outlay for cash dividends just as critical as that for capital expenditure. While a company's board of directors can reduce and/or suspend paying a dividend. This could impact investment sentiment thus representing a possible downside risk for the stock price.
5.3 Cash Flow Coverage Ratios
This ratio measures the ability of the company's operating cash flow to meet its obligations - including its liabilities or ongoing concern costs. The larger the coverage for these items, the greater the company's ability to meet its obligations, along with giving it a greater amount of cash flow to expand its business, withstand unfavorable business cycles and not be burdened by the debt servicing and other restrictions typically included in credit agreements.
5.3.1 Short –term Debt Coverage Ratio
Operating Cash Flow
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Short-term Debt
The short-term debt coverage ratio compares the sum of a company's short-term borrowings and the current portion of its long-term debt to operating cash flow.
5.3.2 Capital Expenditure Coverage Ratio
Operating Cash Flow
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Capital Expenditure
A positive difference between operating cash flow and capital expenditure defines free cash flow. Therefore, the larger this ratio is, the more cash assets a company has to work with.
5.3.3 Dividend Coverage Ratio
Operating Cash Flow
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Cash Dividends
The dividend coverage ratio provides dividend investors with a viewpoint on the safety of the company's dividend payment
5.3.4 Capex + Cash Dividends Coverage Ratio
Operating Cash Flow
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Capital Expenditure + Cash Dividends
Conservative investors could possibly compare the sum of a company's capital expenditure and cash dividends to its operating cash flow. This is a stringent measurement that puts cash flow to the ultimate test. If a company is able to cover both of these outlays of funds from internal sources and still has cash left over, it is generating what might be termed as "free cash flow on steroids". This indicates high investment quality.
5.4 Dividend Payout Ratio
Dividends Per Share (DPS)
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Earnings Per Share (EPS)
The dividend payout ratio is an indicator of how well earnings support the dividend payment. Investors in dividend-paying stocks expect a consistent and/or gradually increasing dividend payout ratios. A very high dividend payout ratio should be viewed with skepticism. One needs to assess whether the level of dividends is sustainable. Many investors are initially attracted to high dividend-paying stocks, only to be disappointed later by a substantial dividend reduction. In that scenario, there is a downside risk for the company’s share price.
Dividend payout ratios vary widely among companies Large-sized and mature companies who have attained a state of stability in their operations could tend to have larger dividend payouts. Growth-oriented companies tend to keep their cash for expansion purposes, have modest payout ratios or choose not to pay dividends.
6. Investment Valuation
Analysts use these ratios to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.
6.1 Price/Book Ratio
Market Price Per Share
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Shareholder’s Equity Per Share
The price-to-book value ratio, expressed as a multiple (i.e. how many times a company's stock is trading per share as compared to its book value). It is an indication of how much shareholders are paying for the net assets of a company.
If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities:
The first scenario is that the stock is being unfairly/incorrectly undervalued in the short term by investors. This being a temporary phenomenon, the stock represents an attractive buying opportunity at a bargain price. It is assumed that the company's positive fundamentals are still in place and would drive its prices to a much higher level in the future.
On the other hand, one could find the current market's perception about the company as correct. In that case, at least over the foreseeable future, the prices could be stagnant and thus the stock represents a losing investment proposition.
Some analysts feel that since a company's assets are recorded at historical cost that its book value is of limited use. Also, intellectual property rights of a company have assumed critical importance in the current business scenario. However it is difficult to fairly assess this class of assets in terms of value. Thus one finds that book value may well grossly undervalue both the tangible as well as the intangible assets of a company. The ratio is probably more relevant for use by investors looking at capital-intensive or finance-related businesses, such as banks.
6.2 Price/Earnings Ratio
Market Price Per Share
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Earnings Per Share (EPS)
The P/E Ratio is the most the most widely reported valuation metric in the secondary markets. It is an effective analysis tool as long as the company is a viable business entity and its real value is reflected in its profits.
The EPS used in the denominator could be either of the following:
Basic earnings per share - based on the past 12 months as of the most recent reported quarterly net income. In investment research materials, this period is often identified as trailing twelve months (TTM). The term "trailing P/E" is used to identify a P/E ratio calculated on this basis.
Estimated basic earnings per share - based on a forward 12-month projection as of the most recent quarter. This is rather an estimate generated by investment research analysts. The term “estimated P/E ratio” is used to identify a ratio calculated on these forecasts.
High P/E ratio suggests that investors are expecting higher earnings growth in the future and thus the stock could outperform the overall market. Thus they are willing to pay more today to buy that particular growth story. Conversely, a stock with a low P/E ratio suggests that the company does not have adequate growth drivers and thus investors have a more modest expectation as regards its future growth.
One limitation of the P/E Ratio is that the calculation of the denominator (EPS) is merely an accounting exercise, which is susceptible to assumptions, interpretations and management manipulation. This means that the quality of the P/E ratio is only as good as the quality of the underlying earnings number.
It is worthwhile to look at the current P/E ratio for the overall market (Sensex, Nifty), the company's industry segment, and two or three direct competitors.
6.3 Price/Sales Ratio
Market Price Per Share
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Sales / Revenue Per Share
This ratio indicates how much investors are willing to pay for a rupee of the company's sales rather than its earnings.
However, since the company might be unprofitable, its sales figure does not reveal the whole picture. Turnover is valuable only if, at some point, it can be translated into earnings. Examination of sales must be done along with a study of profit margins as well as with sector-specific performance trends.
Consider a highly cyclical industry where there could be certain when only a few companies report any earnings. However the company’s stock would still be having an intrinsic worth. The Price / Sales Ratio comes in handy to ascribe a value in such a scenario.
On similar lines, when a company begins to suffer losses and consequently has no earnings (and thus P/E ratio cannot be computed). Sales based valuation ratios are useful in such a scenario as they indicate what a company with temporary adverse margins would be worth if the same could be returned to normal in circumstances where investors would expect either a turnaround (i.e. a return to business as usual) or a take-over.
Many people look at sales revenue as a more reliable indicator of a company's growth as compared earnings, This is because the earnings figure is prone, to a greater extent, to accounting jugglery.
6.4 EV/EBITDA
Enterprise Value (Market Cap. + Preferred Stock + Debt – Cash & Cash Equivalents)
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Earnings before Interest Taxation Depreciation & Amortisation
As an approx calculation, the EV/EBITDA multiple serves as a proxy for how long it would take for an acquisition to earn enough to pay off its costs (assuming no change in EBITDA).
The main advantage of EV/EBITDA over the PE ratio is that it is unaffected by a company's capital structure, in accordance with capital structure irrelevance theory.
Secondly, EV/EBITDA also strips out the effect of depreciation and amortization. These are non-cash items, and it is ultimately cash flows that matter to investor
If a company has subsidiaries that are not wholly owned ones, while preparing the consolidated P&L we incorporate profits from these subsidiaries in their entirety and then make an adjustment later for Minority Interest. So the EBITDA calculated by taking the operating profits from the consolidated P&L account, will be the EBITDA for the group and not that of the company. One way to adjust for this phenomenon is to include only that portion of the subsidiary’s EBITDA as that belongs to the parent. So if the holding company has a 75% stake in its subsidiary, we should include only 75% of the subsidiary's EBITDA in the calculation
As with P/E it is common to look at EV/EBITDA using forecast profits rather than historical ones.
