9.1 – Role of Financial Ratios
In the last few chapters, we have learned to read financial statements. Now we will learn to analyze them. For this, we have to first understand the financial ratios. Financial ratios were first introduced by a fundamental analyst named Benjamin Graham. _ _ them financial ratio Considered the father of. Through financial ratios, we can assess the financial results of the company. Current performance can be measured against the performance of previous years, previous quarters, and other companies. Financial ratios are usually included in the company’s financial statements or financial statements.
‘ s data is used. _ Before understanding financial ratios, we need to know some of their important principles. Financial ratios by themselves do not provide much information. _ _ For example, if I am told that the profit of UltraTech Cement is 15%.
If so, what will I know from this? It is true that a 15 % return is a good return, but is it the best return in the sector? _ Suppose you know that the profit of ACC Cement is 12 % and when we compare this profit with Ultratech _
If we do with the profit of Cement, then we will come to know that the profit of UltraTech is higher than that of ACC Cement. You must have understood from this that the ratio in itself does not tell much, but when it is used for any comparison You see the full picture. That is, it means that whenever you take out the ratio, it will be better if you use it for any comparison. Another important thing that you have to remember while calculating the ratio is that each company has its own unique _ _There is accounting policy. Accounting policies may also differ from financial year to year. _ _ _ That’s why you should have this information while using the ratio.
9.2 – Financial Ratios
Broadly financial ratios can be divided into 4 parts. _ _ _
- Profitability Ratios _ _ _ _ _ _
- Leverage Ratios _
- Valuation Ratios _ _
- Operating Ratios _
Profitability Ratio, as the name suggests, shows the profitability of the company. _ _ _ _ _ _ _ This also shows how well the company is running, and how good is its management. _ _ _ _ Company by profitability _ _ _ _ Plans for expansion goes on, and dividend is given to the shareholder, hence profit or profit is the most important ratio for the shareholder.
The leverage ratio is also sometimes referred to as the solvency ratio or gearing ratio. This ratio shows how well the company can run its business for a long period of time in the coming times . _ _ This also shows that the company has to plan for its expansion. How much loan is she using Remember that a company has to pay a variety of bills and fulfill other responsibilities in order to run its business properly. _ _ _ _ _ Solvency ratio tells us that the company is able to meet these responsibilities. _ How capable I am.
Valuation ratios are used to compare the cost of a company’s shares with its earnings. _ _ _ _ This shows whether the price of the company’s shares is less or more than its profit. _ Are shares expensive or cheap? this also shows _ _ What is the net worth of the company and how much are the shares worth against that? This ratio of the company is closely watched before buying the shares. _ _
The operating ratio, also known as the activity ratio, tells how well a company can use its assets to grow its business. _ _ _ _ _ It also shows how the management of the company is. _ That is why sometimes it is also called the management ratio. Huh. In fact, every ratio gives a message about the financial health of a company as the profitability ratio tells about the efficiency of the company’s operations. _ Sometimes it is also known from the operating ratio. That’s why it is a little difficult to divide the ratios into different categories.
It is a difficult task, but still, roughly they can be divided into the four parts mentioned above. _ _ _
9.3 – Profitability Ratio
Under the profitability ratio, we will look at the following ratios: 1. EBITDA Margin ( Operating Profit Margin ) – EBITDA Growth Rate ( CAGR Growth) 2. PAT Margin – PAT Growth Rate ( CAGR Growth) 3. Return on Equity ( ROE ) ) 4. Return on Asset ( ROA) 5. Return on Capital Employed
( ROCE) EBITDA Margin :
The Earnings Before Interest Tax Depreciation and Amortization ( EBITDA) margin indicates the efficiency of the company’s management. It also shows how the company is doing business. _ _ _ How much profit ( in percentage ) is the company making in turnover? Company to this margin _ By comparing with other companies we get to know how well the company is keeping its costs under control. _ _ To know the EBITDA margin we first have to know the company’s EBITDA. EBITDA = [ Operating Revenues –
Operating Expenses ] Operating Income = [ Total Revenue – Other Income ] Operating Expense = [ Total Expense – Finance Cost – Depreciation & Amortization ] EBITDA Margin = EBITDA / [ Total Income – Other Earnings ] For example, let’s work out the FY 14 EBITDA margin of Amara Raja Batteries: First
EBITDA : [ Net Income – Other Income ] – [ Net Expenses – Finance Cost – Depreciation & Amortization ] Remember that other income comes from investments and other non-business sources so including it in EBITDA will not give a true picture. [3482-46] – [2942-0.7-65] =  –  = 560
Rs crore EBITDA margin 560/3436 = 16.3% Here are 2 questions :
- What does the EBITDA of Rs 560 crores indicate and what does the EBITDA margin of 16.3% indicate?
- Is 16.3% EBITDA Margin Good or Bad?
The answer to the first question is quite simple, the company made an operating income of ₹ 3436 crore and saved ₹ 560 out of it. It also means that the company spent ₹ 2876 crores out of an income of ₹ 3436 crores. In percentage terms, the company spent 83.7% of its income . did and saved 16.3% of the income for the business.
Now let’s see the answer to the second question. Humne pahle bhi baat ki hai ki hai ki financial ratio apne aap mein kuch khas informa nahin dete hain . To extract performance information from it we have to compare it with another company from last year. _ _ _ _ Company K 16.3% EBITDA To understand the meaning of margin, let us look at the 4-year trend of Amara Raja Battery’s EBITDA margin.
|year||operating income||operating expenses||EBITDA||EBITDA margin|
It seems that the EBITDA of ARBL is generally around 15 % on average. _ A closer look shows that its EBITDA margin is slowly increasing. _ _ _ _ _ This is a good sign which indicates that the performance of the company is not only stable but Keeps getting better. _ It also shows the efficiency of the company’s management. The EBITDA of the company in the year 2011 was Rs.257 crore and in 2014 it is at Rs.560 crore. This means that the CAGR ( growth ) of EBITDA in 4 years has been 21%. it
Clearly, both EBITDA margin and EBITDA CAGR growth are all pretty good. But we don’t know how it compares to other companies. _ _ _ In the case of ARBL you should compare it with the EBITDA of Exide Batteries Ltd.
The EBITDA margin is measured at the operating level of the company’s turnover while the PAT margin is seen as the bottom-line profit of the company. In operating margin we include only operating expenses, it excludes depreciation and financial cost. _ _ _ _ _ _ Tax expenses also remain separate while the PAT margin includes these . _ _ _ When the PAT margin is calculated, all kinds of expenses are subtracted from the total revenue then the total final profit of the company is found out. _ _ PAT margin = [ PAT / total
Income (Total Revenue) ] PAT of the company is stated very clearly in the annual report. This ARBL ‘s FY 14 PAT was Rs.367 Crore while the company’s income was Rs.3482 Crore. The PAT margin of the company on this basis is 367 / 3482 = 10.5% PAT of ARBL over the years and
Let’s take a look at how the PAT margin has fared :
|year||PAT (in Rs crore )||PAT margin|
The stock and PAT margin performance of the company is looking very good. We can see that the margin of the company is increasing continuously, it is growing at a CAGR of 25.48% in the last 4 years which is quite well. But compared to other competing companies _ _ _ Only after doing this will we know the true picture.
Return on Equity ( ROE)
Return on Equity is a very important ratio that tells us how much the shareholders of the company are earning on their investment. _ _ _ It tells how much profit the company is earning on the investment of the shareholders. Higher the ROE better for the shareholders _ _ _ Will happen. In fact, this becomes a very important factor to identify an investable company. _ _ For your information, the best companies in India have ROE between 14 % to 16 %, but personally I prefer those companies which have an ROE of 18 % _ _ _ _ be more than _ This ratio is also compared with other companies operating in that industry. _ _ _ _ It is also compared with past historical figures. _ _ Also note that a high ROE means that the company has a lot of cash on hand. _
is coming and the need for the company to take debt or raise money from outside is going to reduce. Therefore, a good ROE means that the management of the company is doing a good job.
The equation to calculate ROE : [ Net Profit / Shareholders ‘ Equity * 100 ]
ROE is a good ratio but like many other ratios, it also has some drawbacks. Let us see an example to understand them better. _ Suppose Vishal runs a Pizza store. _ For making pizza he needs an oven which costs ₹ 10000. _ _ _ Oven
An asset to Vishal. _ He does not take any loan to buy it but buys it with his own money. In this case, the shareholder’s equity on its balance sheet will be ₹ 10000 and the assets will also be ₹ 10000. Now suppose in the first year of business Vishal got Rs.
2500 is the profit. What happened to his ROE? This is quite easy: ROE = 2500 /10000 *100 =25.0% Now let’s change the situation a bit. Suppose Vishal has ₹ 8000 and borrows ₹ 2000 from his father to buy an oven worth ₹ 10000. _ _ _ _ _ Now hers
What will the balance sheet look like? The liabilities side of the balance sheet would have shareholder equity of ₹ 8,000 and debt of ₹ 2,000. Thus its total liability of Vishal will be ₹ 10000. Balancing this, he will have an asset of ₹ 10000 on the asset side as well. see now What is his ROE: In the liability part he will have: Shareholders ‘ Equity = Rs.8000 Debt = Rs.2000 Now Vishal’s total liabilities are Rs.10000 and assets are Rs.10000 . Now let’s see the ROE: ROE = 2500/8000*100 =31.25% Vishal’s ROE is very high due to this debt has increased. Now suppose Vishal had only ₹ 5000 and he had to take a loan of ₹ 5000 from his father, then how would his balance sheet look? On the part of liability, he would have: Shareholders ‘ Equity = ₹ 5000 Debt = ₹ 5000 Total
In total, his liability would have been ₹ 10000 and his share of assets would have been ₹ 10000. In this case, his ROE would look like this: ROE = 2500 / 5000*100 = 50%. You can see that as Vishal’s debt is increasing, so is Its ROE is also increasing. high ROE good
It happens but not with debt because as the debt increases, it becomes risky to run the business because the financial cost increases . _ _ _ _ A good way to figure this out is to apply the Dupont Model, also known as the Dupont Identity. Huh. This model was developed in 1920 by a company named DuPont. _ In this model, the ROE formula is divided into three parts and each part represents a specific part of the business. _ DuPont analysis includes both the balance sheet and P&L statement of the business.
is used. _ ROE under this model is calculated as follows: _ _ _
If you observe carefully, in this formula the numerator and denominator cancel each other out, and finally we are left with the original ROE formula: ROE = Net Profit / Share Holders Equity * _ _ _ _ _ _ _ 100 but the advantage is that _
That we get a chance to look into three different parts of the business. Let’s look at the three parts of this model :
- Net Profit Margin = Net Profit / Net Sales * 100 This is the first part of the DuPont model that shows the profit-making potential of this company. But in reality, it is nothing but PAT Margins whose fall means that the cost of the company _ _ _
is high and he is facing tough competition. _ _ _
- Asset Turnover = Net Sales / Average Total Asset The asset turnover ratio shows how well a company is using its assets to generate revenue. _ _ _ _ _ _ _ The higher the ratio, the more efficient the company is considered. _
When this ratio is low, it is believed that the management of the company is not good or its production is facing difficulty. _ The number per year is given to show this. _
- Financial Leverage = Average Total Assets / Shareholders Equity In the financial leverage ratio, we come to know how many units of assets the company has per unit of shareholder equity of the company. For example, if the financial leverage is 4, then
This means that for every ₹ 1 in equity, the company has ₹ 4 in assets. If the financial leverage ratio of the company is high and the company has taken a lot of debt, investors should be careful while investing in such a company.
As you can see, the DuPont model breaks down the ROE formula into three distinct parts. Each part gives a picture of the company’s performance and financial strength. _ Now we use this model to calculate the ROE of Amara Raja Battery for FY14 _ _
Let ‘s do
Net Profit Margin: As mentioned earlier this is nothing but PAT Margin. _ _ _ We have already worked out the PAT margin of Amara Raja Batteries ie ARBL and it is 9.2%. Asset Turnover = Net Sales / Average Total Assets We know that for FY14 _
According to the annual report, the total sales of ARBL is Rs.3437 crores. Here the denominator is Average Total Assets. We know that we can extract the asset figure from the balance sheet, but what does average mean here? _ _ _ In the balance sheet of ARBL
The total assets have been shown as Rs.2139 crores. But the thing to note here is that this figure is for the financial year 2014 which starts on 1 April 2013 and ends on 31 March 2014. _ _ _ This means that the company has _ _ _ _ Initially ( April 2013 ) when it started functioning it had some assets which belonged to FY13 and which were brought forward from there. _ _ _ _ _ Later ( in FY14 ) some new assets were also added and all these assets together worth Rs 2139 crore _ _ Happened. This means that the assets held by the company at the beginning of the year are worth one thing and the assets are worth another at the end of the year. Keeping this in mind, we will now calculate the asset turnover ratio, so what is the value of the asset?
Should be taken – at the beginning of the year or the end of the year? To overcome this dilemma, the average price of the asset is arrived at. Remember this technique for finding the average of a line item, you will need to use it to find other ratios as well. ARBL
From Annual Report we know that : FY14 Net Sales = Rs.3437 Crore FY13 Total Asset = Rs.1770 Crore FY14 Total Asset = Rs.2139 Crore Average Total Asset = (1770+2139) / 2 = 1954.50 Asset Turnover = 3437 / 1954.50 = 1.75 This means that for every Rs . _ _ _ _
The company is earning Rs 1.75. _ Now let’s calculate the last part of Financial Leverage: Financial Leverage = Average Total Assets / Shareholders ‘ Equity We know that the average value of total assets is Rs.1955 crores. All we have to do is find out the shareholder’s equity. the way we
Instead of looking at current assets, we will look at average shareholders ‘ equity and not just shareholders ‘ equity for the current year. FY13 Shareholders ‘ Equity = Rs 1059 Crore FY14 Shareholders ‘ Equity = Rs 1362 Crore Average Shareholders’ Equity = Rs 1211 Crore Financial Leverage
=1955/1211 = 1.61 Since ARBL has very little debt hence the financial leverage is 1.61 which is a good figure. This means that for every Re 1 of shareholder’s equity, ARBL has assets worth Rs 1.61. _ _ _ _ Now we calculate the ROE of ARBL are: ROE = Net Profit Margin x Asset Turnover x Financial Leverage = 9.2%*1.75*1.61 = 25.9% This is a long way of calculating ROE. But it’s also probably the best approach because it gives us a good idea of many different parts of any business. _ _ _
get information from. _ _ The DuPont model tells us not only about a company’s returns but also about the quality of those returns. _ _ _ _ _ By the way, if you are in a hurry to calculate ROE, use this equation: ROE = Net
Profit / Average Shareholder Equity as per Annual Report PAT for FY14 is 367 Cr ROE =367 / 1211 = 30.31% Return on Asset (ROA )
After understanding the DuPont model, it will be easy to understand the next two financial ratios. Return on Assets or ROA tells us how much profit a company can generate using its assets. _ _ _ A good company does not invest in such an asset that does not benefit it. ROA tells us the type of assets the company’s management is investing in. _ _ The higher the ROA of the company, the better it is for the company. ROA = [ Net Income + Interest *(1- Tax Rate )] / Total Average Assets As per Annual Report : FY14 Net
Income = 367.4 crore Total average assets we had withdrawn = 1955 crore But what does interest * ( 1- tax rate ) mean here? Just think about it, the company will use the debt it has taken to buy assets to make a profit. So in this way
Those people who have given loans to the company also become the shareholders of the company. Also, the company has to pay less tax as the interest has already been paid. This is called a tax shield. Because of this, whenever we take out the ROA of the company, we have Interest ( from the point of view of tax shield ) also has to be added. If the total interest ( finance cost ) is 7 crores, then the tax shield will be = 7 *(1-32%), where the average tax rate is assumed to be 32%. =4.76 Cr , So , ROA = [367.4 + 4.76] /1955 ~ 372.16 / 1955 ~ 19.03%
Return on Capital Employed (ROCE) Return on Capital Employed tells us how much profit the company is earning from the amount of capital employed in the company. _ _ Total capital or capital includes both equity and debt ie equity and debt. _ _ ROCE = [ Profit before Interest & Taxes ]
/ Overall Capital Employed ] Total Capital Employed = Short Term Debt + Long Term Debt + Equity As per ARBL Annual Report : Profit Before Interest & Tax = 537.7 Crore Total Capital Employed : Short Term Debt = 8.3 Crore Long Term Debt = 75.9 crores
Shareholder Equity = 1362 crore Total Capital Employed : 8.3 + 75.9 + 1362 = 1446.2 crore ROCE = 537.7 / 1446.2 = 37.18 % Highlights of this chapter
- Financial ratios are a very important way of examining or measuring any company, but financial ratios by themselves provide very little information. _ _ _ _
- The best use of the ratio is when you compare it with past data or with another company in the industry that is competing with this company. _ _ _ _
- Financial ratios can be divided into 4 parts namely profitability, leverage, valuation, and operating ratios. _ These four parts give different information about the company to an analyst. _ _ _ _ _ _
- The amount left after deducting operating expenses from operating income is called EBITDA . _ _ _
- EBITDA margin shows the percentage profit of the company at the operating level.
- PAT margin shows the total profit of the company. _ _
- Return on Equity ie ROE is a very important ratio that tells how much money the shareholders of the company are earning on the initial investment.
- A high ROE and high debt are not very good signs.
- The DuPont model is used to break down a company’s ROE into separate segments that provide accurate information about the different segments of the company’s business. _ _ _ _ _ _ _
- The DuPont model is probably the best model for calculating the ROE of a company.
- Return on Assets tells how well the company is using its assets. _ _ _ _
- Return on Capital Employed tells how the company is using its debt and equity and how much return it is earning on it. _ _ _
- Good use of any ratio is when it is used in comparison to some method. _ _ _ _
- Ratios can be used for comparison at a point or point of time and also for comparison over a longer period of time.