Fundamental analysis has two aspects – one aspect describes the general (qualitative) factors of a company whereas the other aspect focus on tangible and measurable factors (quantitative). This means analysing Financial Statements is not enough, one should also be able to analyse and crunch the numbers behind the financial statements.
If used in conjunction with other methods, quantitative analysis can produce excellent results.
When we speak of qualitative analysis then generally we are referring to quality parameters of a company like products of a company, management behaviour, company’s growth, competitive advantage of a company etc.
When we speak of quantitative analysis then generally we are going to play with numbers that is we will do some mathematical calculations to analyse a company.
When we speak about Ratio analysis we are not just comparing different numbers from the balance sheet, income statement and cash flow statement but in actuality it is the process of comparing the numbers against previous years, other companies, the industry or even the economy in general. Ratios look at the relationships between individual values and relate them to performance of the company in the past, and get some overview of how the company might perform in the future.
For example, the current assets of the company don’t tell us everything about the company but as soon as we divide them by current liabilities we are able to determine whether the company has enough money to cover short-term debts. This is where the need of ratio analysis of Financial Statements come in.
In this chapter we’ll learn how to use Ratio Analysis to analyse financial statements of any company. When we compare these ratios against numbers from previous years, other companies, industry averages and the economy in general we can learn a lot about where a company is heading.
Ratio Analysis or sometimes also called Financial ratios are of following types :
1) Profitability Ratios
2) Liquidity Ratios
3) Management Efficiency Ratios
4) Leverage Ratios
5) Valuation and Growth Ratios
Let’s learn about all the ratios in detail :
1. Profitabiltiy Ratios :
Profit is the primary objective of all businesses. Profitability ratios are a part of financial ratios that are used to measure company’s ability to generate profits when compared to its expenses and other relevant costs incurred during a specific period of time.
If these ratios have a higher value relative to a competitor’s ratios or relative to the same ratio from a previous period, then it indicates that the company is doing well.
Profitability ratios are used by almost all the parties connected with the business:
- A strong profitability position ensures common stockholders a higher dividend income and appreciation in the value of the common stock in future.
- Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed dividend income if the business has good profitability position.
- Management needs higher profits to pay dividends and reinvest a portion in the business to increase the production capacity and strengthen the overall financial position of the company.
Let’s look at the following ratios that forms a part of Profitability Ratios :
a) EBITDA Margin : EBITDA margin is a measurement of company’s operating profitability as a percentage of its total revenue. Full form of EBITDA is Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) divided by Total revenue. Because EBITDA excludes interest, depreciation, amortization and taxes, EBITDA margin helps all investors, business owner and financial professionals to know company’s operating profitability and cash flow.
To calculate EBITDA Margin, we need to know EBITDA first.
EBITDA = [Operating Revenues – Operating Expense]
Operating Revenues = [Total Revenue – Other Income]
Operating Expense = [Total Expense – Finance Cost – Depreciation and Amortization]
EBIDTA Margin = EBITDA / [Total Revenue – Other Income]
Continuing with the example of Hero MotoCorp Limited for which the snapshot is given below, the EBITDA Margin calculation for the FY16 is as follows:
We will first calculate EBITDA , which is calculated as follows:
Note : The values used in below formula are marked in Blue and Green in above snapshot.
[Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation & Amortization]
[28990 – 391] – [24595 – 2.15 – 441]
=  – [24151.85]
= 4,447.15 Crores
Hence the EBITDA Margin is:
= 4447 / 28599
= 15.52 %
Now this EBITDA margin is compared to EBITDA margins of previous years and with other competitors which gives an assessment of company’s performance and future growth.
b) PAT Margin : We have already discussed about PAT which is Profit After taxes in previous chapters.
PAT margin is calculated as [Profits After Tax / Total Revenue].
Continuing with Hero MotoCorp, Its PAT for FY16 is 3132.37 Crore Rupees and Total revenues is 28,990 Crore Rupees.
Therefore, putting values in above formula we get,
PAT Margin = [3132.37/28990]
c) Return on Equity (ROE) : ROE is how much returns a company gives to its shareholders in a particular year. ROE is a ratio that is of major concern to company’s shareholders, since it gives them an estimate of the earning return on their equity investments.
In simple words, ROE is an ability of the company to give better returns to its shareholders.
Higher the ROE, higher are the returns.
RoE can be calculated as : [Net Income (PAT) / Shareholders Equity]
If a company ABC makes 30 Crore Rupees in PAT. ABC also has 150 Crore Rupees as Shareholders Equity (Note: Equity Share Capital + Reserves = Net Worth = Shareholders Equity).
In this case ROE of ABC would be:
ROE = 30/150 = 20%
This means Company ABC has given 20% Returns on Equities to its shareholders.
d) Return On Assets (ROA) : In financial analysis, it is the measure of the return on investment. ROA is used in evaluating management’s efficiency in using assets to generate income.
The formula for return on assets is:
RoA = [Net Income (PAT)/ Total Assets]
Let’s find RoA for Hero MotoCorp Ltd.
RoA = [3132/12340]
2. Leverage Ratios :
A leverage is a form of debt taken by the company to finance its operations. A leverage ratio is one of several financial measurements which assess how much capital comes in the form of debt (loans), or measures the ability of a company to meet financial obligations.
Too much debt can be dangerous a situation for any company and its investors as uncontrolled debt levels can lead to credit downgrades or can make the situation worse. If a company’s operations can generate a higher rate of return than the interest rate on its loans, then the debt is actually helping to fuel growth in profits.
There are several different specific ratios that may be categorized as a leverage ratio, but the main factors considered are debt, equity, assets and interest expenses. Let’s look at each of them individually.
a) Debt to Equity Ratio : Debt/Equity Ratio is a debt ratio used to assess company’s financial leverage. It is calculated by dividing a company’s total liabilities by its stockholders’ equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
A D/E ratio of more than 1 implies that the company is a leveraged firm and if D/E ratio is less than 1 then the company is a conservative one.
The formula for calculating D/E ratios can be represented in the following way:
Debt to Equity Ratio = [Total Debt / Shareholders’ Equity]
The result is often expressed as a number or as a percentage.
Let’s find Debt to Equity of a company named ‘ABC’. Snapshot of balance sheet of ABC is shown below:
Total Debt = [Short term borrowings + Long term borrowings]
= [3427 + 5592]
= 9,019 Crore Rupees.
Let’s assume Total Shareholders’ equity of company ABC is Rs. 7,226 Crores.
D/E = 9019/7226
b) Debt-to-Asset (D/A) : This ratio helps to understand how much debt is used to finance all the assets of the company.
Debt-to-Assets = Total Debt/ Total Assets
Total Debt = [Short term borrowings + Long term borrowings]
= [3427 + 5592]
= 9,019 Crore Rupees.
Total Assets = 15,754 Crore Rupees
D/A = 9019/15754
This shows 57% of the Assets are financed by Debts.
3. Liquidity Ratios :
Liquidity ratios is used to assess a company’s ability to pay its debt. It also gives an estimate of an company’s ability to use money in case of an emergency or cash crunch. Liquidity ratios also indicate cash flow positions of the company. In simple words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other liabilities.
Some of the liquidity ratios are as follows :
a) Current Ratio :
The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are should be paid off within a year.
This means that the company has a very short period time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.
The current ratio is calculated by dividing current assets by current liabilities.
Here is the calculation:
b) Quick Ratio :
The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable fall in category of quick assets.
The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base metal and of no value.
The acid test of finance shows how quickly a company can convert its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.
The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current receivables together then dividing them by current liabilities.
Sometimes company financial statements don’t give a breakdown of quick assets on the balance sheet. In this case, you can still calculate the quick ratio even if some of the quick asset totals are unknown. Simply subtract inventory and any current prepaid assets from the current asset total for the numerator. Here is an example.
4. Valuation ratios :
Valuation is the process used in finance to determining worth of a company. Valuation ratios put that insight into the context of a company’s share price, where they serve as useful tools for evaluating investment potential. It is a measure of how cheap or expensive a company is, compared to some measure of profit or value.
a) Price Earnings P/E Ratio :
The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market prospect ratio that calculates the market value of a stock relative to its earnings by comparing the market price per share by the earnings per share. In other words, the price earnings ratio shows what the market is willing to pay for a stock based on its current earnings.
Investors often use this ratio to evaluate what a stock’s fair market value should be by predicting future earnings per share. Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future.
Obviously, fair market value of a stock is based on more than just predicted future earnings. Investor speculation and demand also help increase a share’s price over time.
The PE ratio helps investors analyse how much they should pay for a stock based on its current earnings. This is why the price to earnings ratio is often called a price multiple or earnings multiple. Investors use this ratio to decide what multiple of earnings a share is worth. In other words, how many times earnings they are willing to pay.
Formula for P/E ratio is :
The price to earnings ratio indicates the expected price of a share based on its earnings. As a company’s earnings per share being to rise, so does their market value per share. A company with a high P/E ratio usually indicated positive future performance and investors are willing to pay more for this company’s shares.
A company with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could prove to be a poor investment.
In general, a higher ratio means that investors anticipate higher performance and growth in the future. It also means that companies with losses have poor PE ratios.
An important thing to remember is that this ratio is only useful in comparing like companies in the same industry. Since this ratio is based on the earnings per share calculation, management can easily manipulate it with specific accounting techniques.
Continuing with the example of Hero MotoCorp, as we already know from the previous chapters,
EPS of Hero MotoCorp is Rs. 156.84 /-
EPS = PAT/No. of Outstanding shares
Current Market Price of Hero MotoCorp = Rs. 3,080 /-
P/E = 3080 / 156.8
b) Price to Book Ratio :
The price to book ratio, also called the P/B or market to book ratio, is a financial valuation tool used to evaluate whether the stock a company is overvalued or undervalued by comparing the price of all outstanding shares with the net assets of the company. In other words, it’s a calculation that measures the difference between the book value and the total share price of the company.
This comparison demonstrates the difference between the market value and book value of a company. The market value equals the current stock price of all outstanding shares. This is the price that the market thinks the company is worth. The book value, on the other hand, comes from the balance sheet. It equals the net assets of the company.
Investors and analysts use this comparison to differentiate between the true value of a publicly traded company and investor speculation. For example, a company with no assets and a visionary plan that is able to drum up a lot of hype can have investors drooling over it. Thus, causing the stock price to increase quarter over quarter. The book value of the company hasn’t changed though. The business still has no assets.
Investors use both of these formats to help determine whether a company is overpriced or under-priced. For example, a P/B ratio above 1 indicates that the investors are willing to pay more for the company than its net assets are worth. This could indicate that the company has healthy future profit projections and the investors are willing to pay a premium for that possibility.
If the market book ratio is less than 1, on the other hand, the company’s stock price is selling for less than their assets are actually worth. This company is undervalued for some reason. Investors could theoretically buy all of the outstanding shares of the company, liquidate the assets, and earn a profit because the assets are worth more than the cumulative stock price. Although in reality, this strategy probably wouldn’t work.
This valuation method is only one that investors use to see if an investment is overpriced. Keep in mind that this method doesn’t take dividends into consideration. Investors are almost always willing to pay more for shares that will regularly and reliability issue a dividend. There are many other factors like this that this basic calculation doesn’t take into account. The real purpose of it is to give investors a rough idea as to whether the sale price is close to what it should be.
Before we learn how to calculate price to book ratio, let’s first understand how to calculate book value.
Book Value (BV) of a company is simply the total value of all the Assets of a company after paying-off all liabilities and excluding all intangible assets.
It is used to determine the level of safety associated with each individual share after all debts are paid off.
BV = [Total Shareholders’ equity] / Total Outstanding shares
Let’s take a look at how to calculate the price to book ratio.
Total Shareholders equity = Share Capital + Reserves
= [39.94 + 7904] Crore Rupees
= 7943.94 Crore Rupees
Total Outstanding shares = 19.96 Crores
Book Value (BV) = 7943.94/19.96
= Rs. 398 /-
This means if all the shares of Hero MotoCorp are liquidated then each shareholder will get Rs. 398 /-
The price-to-book ratio formula is calculated by dividing the market price per share by book value per share.
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