Fundamental Analysis

Financial Ratio Analysis (Part 2) – Poonit Rathore

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Financial Ratio Analysis (Part 2) - Poonit Rathore
Financial Ratio Analysis (Part 2) – Poonit Rathore

10.1 The Leverage Ratios

We talked about financial leverage while discussing return on equity and DuPont analysis. Leverage means the use of debt is like a double-edged sword.

The best companies take loans, especially when they see that they can earn more money from the loan money than the interest they pay on the loan. You know that the asset created through debt also increases the return and equity.

But when the company takes a lot of debt, then due to paying interest on the debt, the profit earned by the shareholder gets reduced. That is why there is very little difference between a good loan and a bad loan. The leverage ratio tells us how much debt the company has and its debt position.

We will look at the following leverage ratios:

  1. Interest Coverage Ratio
  2. Debt to Equity Ratio
  3. Debt to Asset Ratio
  4. Financial Leverage Ratio

So far we have taken Amara Raja Batteries Limited (ARBL) as an example. But to understand leverage better, we need a company that has a lot of debt on its balance sheet. That’s why I have selected Jain Irrigation Systems Limited. You can also use the company of your choice.

Interest coverage ratio

The interest coverage ratio is sometimes also called Debt Service Ratio or Debt Service Coverage Ratio. The interest coverage ratio tells us how much the company is earning against its debt burden. This tells us how easily the company can pay its interest. For example, if the company has a debt of Rs.100 and its earning are Rs.400 then we can easily see that the company has enough money to repay its debt. But if the interest coverage ratio is low, it means that the debt burden of the company is high and the probability of bankruptcy of the company is high.

Formula to calculate interest coverage ratio:

Earnings Before Interest & Tax / Interest Payment

Earning before interest and tax (EBIT) =

EBITDA – Depreciation & Amortization

Jain Irrigation Systems Limited uses this ratio. Given below is the P&L statement of Jain Irrigation Systems for FY14. I have highlighted the finance cost of the company in the red. We know that EBITDA = [Revenue – Expense]

To calculate the cost, we have to deduct the finance cost (467.64 cr) and depreciation and amortization cost (204.54 cr) from the total cost of Rs 5730.34 cr.

Now EBITDA = 5828.13 – 5058.15

= Rs 769.98 crore

we know that

EBIT = EBITDA – Depreciation and Amortization

= 769.98 – 204.54

= Rs 565.44 crore

Finance cost of the company = 467.64

Hence the interest coverage will be: 

= 565.44 / 467.64

= 1.209 X

Means 1.209 times.

This means that if the company has to pay interest of ₹1, it is earning 1.209 times it.

Debt to equity ratio

It is very easy to extract this ratio. You will easily find both the figures used in this in the balance sheet. In this, you have to measure the difference between the debt capital and equity capital of the company. Here a ratio of 1 means that the company has equal debt and equity. If this figure is more than 1, then it means that the leverage in the company is high and you need to be a little careful. If this figure is below 1, it means that the company has more equity and less debt.

The formula to calculate debt-equity ratio is:

 Total Debt means Total Debt / Total Equity means Total Equity

Keep in mind that total debt means both short-term debt and long-term debt.

Let us look again at JSIL’s balance sheet: Total Debt = Long-Term Debt + Short-Term Debt

= 1497.663 + 2188.915

= 3686.578 crores

Total equity is 2175.549 crores

So, now the debt-to-equity ratio will be 

= 3686.578 / 2175.549

= 1.69

Debt to asset ratio

This ratio tells us how the company is financing its assets i.e. how much of the assets are being brought in through debt.

The formula to calculate it is:

Total Debt / Total Assets 

We know the total debt is 3686.578 crores

Total assets as per balance sheet 8204.447 crore

So now the debt-to-asset ratio is:

=3686.578 / 8204.44

0.449 is 45%

 This means that around 45% of assets have been brought in through debt, while only 55% of assets have been brought in through promoters or owners. The higher this percentage, the more it is a matter of concern for investors.

 financial leverage ratio

We discussed it briefly in the previous chapter also when we were talking about return on equity. This ratio tells us how many units of assets a company has per unit of shareholder equity. _

The formula to calculate the financial leverage ratio is: Average Total Asset / Average Total Equity

From the FY14 balance sheet of JISL, we know that Average Total Assets is 8012.615 while Average Total Equity is 2171.755 Crore. So the financial leverage ratio or leverage ratio will be:

8012.615 / 2171.755

3.68

 This means that JISL has created assets worth Rs 3.68 on equity of Rs 1. Remember that the higher this figure is, the more leveraged the company is.

10.2 – Operating Ratio

Operating ratios show how a company’s operating business is doing. It is also called the activity ratio or management ratio. Operating ratios also show to some extent how efficient the company’s management is. This ratio is also called the asset management ratio and it tells how well the assets of the company are being used.

(Image Credit : Zerodha)

 Some well-known operating ratios are:

  1. Fixed Assets Turnover Ratio
  2. Working Capital Turnover Ratio
  3. Total Asset Turnover Ratio
  4. Inventory Turnover Ratio
  5. Inventory Number of Days
  6. Receivable Turnover Ratio
  7. Days Sales Outstanding (DSO)

The figures for all these ratios are taken from the P&L statement and the balance sheet. To understand these ratios, we will use data from ARBL.

To know whether the company’s ratios are good or bad – the company’s ratios should be compared with the ratios of a competing company.

fixed asset turnover

This ratio tells how much income the company is getting from its fixed asset as compared to the investment made by the company. This shows how well the company is using its plant and equipment. Fixed assets include property, plant, and equipment. The better the company is using its assets, the higher this ratio will be. 

Fixed Asset Turnover = Operating Revenue / Total Average Asset

While taking out the Fixed Assets, we should deduct the Accumulated Depreciation of the company from it as it is the net block of the company. Capital work in progress should also be added to this calculation. Keep in mind that we will take average assets only while calculating. We discussed this in the previous chapter. 

Now let us see the balance sheet of ARBL: 

net average asset

= (767.864+461.847) / 2

= Rs 614.855 crore

FY 14 operating revenue is Rs 3436.7 crore

So now, the Fixed Asset Turnover Ratio is: 

3436.7 / 614.85

= 5.59

While assessing the company on the basis of this ratio, remember that at what stage of development the company is. A well-established company may not be investing much in fixed assets but a growing company will definitely invest in its fixed assets and the value of these assets may increase year after year. You can see that in ARBL the value of Fixed Assets in FY13 was 461.8 Crores which increased to 767.8 Crores in FY14.

This ratio is mostly used in industries where fixed assets are used a lot and in which a lot of capital is required.

working capital turnover

The capital that is needed every day to run the business of the company is called working capital. For this type of work, the company needs a certain type of asset. Such as Inventory, Receivable, and Cash. You know that these are called current assets. A good company uses current liabilities to generate current assets. The difference between current assets and current liabilities is called the working capital of the company.

 Working Capital = Current Assets – Current Liabilities

If the working capital is a positive number, it means that the company has surplus working capital and can run its business smoothly. But if the working capital of the company is negative, it means that the company has a deficit of working capital. If there is a shortage of capital in the company, then they have to take a working capital loan or loan from the bank.

Working capital management is a huge topic in the field of corporate finance. Inventory management, cash management, debtor management, everything comes in this. The CFO i.e. Chief Financial Officer of any company tries to deal with the needs of working capital properly. But we need not go into its details at this point.

The working capital turnover ratio is also known as net sales to working capital. Working capital turnover tells us how much revenue or income the company is making from each unit of its working capital. Suppose this ratio is 4, then it means that the company is earning Rs 4 on every Rs 1 working capital. So it is clear that the higher this ratio is, the better it is for the company. Also, remember that each ratio should be compared with the company’s competitor’s ratio, or you can also compare it with the company’s past record. With this, you will be able to assess the company correctly.

The formula to calculate working capital turnover is 

Working Capital Turnover = Revenue / Average Working Capital

Let us now look at the Working Capital Turnover for Amara Raja Batteries Ltd. For this, first, we have to calculate the working capital of FY13 and FY14 and then calculate its average. Take a look at the Balance Sheet of ARBL, I have highlighted current assets in red and current liabilities in green.

The average working capital for two financial years can be calculated as follows

Current Assets for FY13Rs.1256.85
Current Liability of FY13Rs.576.19
Working Capital of FY13Rs.680.66
Current Assets for FY14Rs.1298.61
Current Liability of FY14Rs.633.70
Working Capital of FY14Rs.664.91
average working capitalRs.672.78

We know that the earnings of ARBL are Rs.3437 crores. Hence working capital turnover ratio will be

= 3437 / 672.78

5.11

This tells us that the company is earning Rs.5.11 for every Rs.1 working capital employed. It is known to us that the higher the working capital turnover ratio better is the company. This means that the company is earning more money than it is spending on its sales.

total asset turnover

This ratio tells how much the company is earning from its assets. Her assets include both fixed assets and current assets. A high total asset turnover indicates that the company is using its assets properly to increase its sales.

Total Asset Turnover = Operating Revenue / Average Total Assets 

The Average Total Assets of ARBL are:

 Total Assets of FY13 1770.5 Crore and Total Assets of FY14 2139.4 Crore. Therefore the average asset will be Rs 1954.95 crore

The operating revenue for FY14 is Rs.3437 crores so the total asset turnover will be:

3437 / 1954.95

= 1.75

inventory turnover ratio

When a company keeps its finished goods in a store or showroom and expects to sell them later to customers, then these goods are called inventory. The company usually keeps some finished goods in its warehouse in addition to its stores.

If the company’s goods are very popular, then its inventory gets over quickly and the company has to prepare new inventory again and again. This is called inventory turnover.

For example, consider a bakery that sells bread. The bakery is very popular. Its owner knows how many loaves of bread he sells every day. For example, suppose he sells 200 loaves of bread a day. This means that he has to keep 200 pieces of bread with him as inventory every day. Inventory turnover in this instance would be quite high.

But it is not necessary to be like this in every type of business. Take for example a car manufacturing company. Car sales are not like bread. If that company makes 50 cars, it will take some time to sell them. Suppose it takes 3 months. This means that every 3 months he has to turn over his inventory. He has to do inventory turnover only 4 times a year. Yes, it is necessary that if the company’s product is popular then its inventory turnover will be slightly higher. This is what the Inventory Turnover Ratio indicates.

The formula to calculate it is: 

Inventory turnover = Cost of goods sold / Average inventory 

The cost of goods sold means the cost incurred in making the finished goods. This is visible to us in the P&L statement. Let’s see it in ARBL.

To know the cost of goods sold, we have to look at the expenses of the company: 

The cost of material consumed is Rs 2101.19 crore and the cost of purchase of stock-in-trade is Rs 211.36 crore. All these line items are related to the cost of goods sold. With this, I would like to see what are the other expenses of the company. So that I can know whether there is any other expenditure that should be included in the cost of goods sold. Information about this has been given here in Note 24.

There are two more costs associated with production – stores and spares. This expenditure is of 44.4 crores. Apart from this, the cost of electricity and fuel is 92.25 crores.

Thus cost of goods sold = cost of material consumed + purchase of stock in trade + stores and spares consumed + power and fuel 

= 2101.19+ 211.36+ 44.94 + 92.25

COGS = 2449.74 crores

In this way, we have got the fraction. Now for the denominator, we need- Average Inventory of FY13 and FY14. The balance sheet states that the inventory of FY13 is 292.85 crores and the inventory of FY14 is 335 crores. In this case, the average becomes 313.92 crores.

The inventory turnover ratio is:

2449.74 / 313.92

7.8

~8 times (in years)

This means that Amara Raja Battery does its inventory turnover 8 times in a year i.e. once in a month and a half. To know whether this figure is good or bad, we have to compare it with the company that is engaged in erotic work.

inventory number of days

The inventory turnover ratio tells us how often a company has to replenish its inventory. The inventory number of days tells us how quickly the company can convert its inventory into cash, meaning how quickly the company’s inventory can be sold. The lower the inventory number of days, the better it is for the company. Fewer inventory days mean that the company’s products are sold out faster.

The formula to find out the inventory number of days is:

Inventory Number of Days = 365 / Inventory Turnover 

The inventory number of days is calculated annually. That’s why in the above formula we have used 365 days of the year.

Let us see the Inventory Number of Days of ARBL:

365 / 7.8

= 46.79

47 days

This means that ARBL takes around 47 days to sell off all its inventory. We should compare this inventory number of days with that of competing company ARBL then only we will know how quickly the company’s products are sold.

Now let’s make you do some exercises. Just imagine:

  1. A company has a very high Inventory Turnover Ratio 
  2. The company has a very low inventory number of days due to a high inventory turnover ratio

Hearing this, you will feel that the inventory management of the company is very good. A high inventory turnover ratio means that the company replenishes its inventory quickly, which is a great thing. Also, a lower inventory number of days indicates that the company is able to sell its inventory more quickly and convert it into cash. This also bodes very well for the inventory management of the company.

 But even if the company’s inventory turnover is high and the inventory number of days is low, but the production capacity is low, many questions arise for the company.

  1. Why is the company not able to increase its production?
  2. Is it not able to increase its production because the company is short of money? 
  3. If he is short of money then why is he not taking a loan from the bank?
  4. Did he go to the bank and the bank refused to give him the loan?
  5. If the bank has refused to give them the loan then why has it happened? 
  6. Is there anything in the records of the company’s management that has led the bank to deny them a loan? 
  7. If money is not a problem then why is the company not increasing its production? 
  8. Is the company not getting the raw material easily?
  9. Can raw material shortage put a halt to the company’s expansion plans?

As you can see if any of the above questions are true then it is a big red flag for the company. It would not be a good idea to invest in such a company. Fundamental analysis should read the annual report carefully to know about any problems related to the company’s production. Especially Management Discussion and Analysis Report must be read from beginning to end.

This also means that whenever you see a company’s inventory figures being very good, you must check how the company’s production is going.

Accounts Receivable Turnover Ratio

The Accounts Receivable Turnover Ratio is the same thing as the Inventory Turnover Ratio. The receivables turnover ratio tells how often a company receives cash from its customers and debtors in a given period of time. The high of this ratio indicates that the company keeps getting cash frequently. 

The formula to calculate it is: 

      Accounts Receivable Turnover Ratio = Revenue / Average Receivables

From the Balance Sheet of ARBL, we know that : 

Trade Receivables of FY13: 380.67 Crore 

Trade Receivables of FY14: 452.78 Crore 

Average Receivables of FY13 – 14: 416.72 Crore

Operating Revenue of FY14: 3437 Crore 

Therefore, the receivables turnover ratio will be: 

3437 / 416.72

=8.24 times every year

~8 times

This means that the company receives cash approximately 8 times a year.

Days Sales Outstanding (DSO) / Average Collection Period / Days Sales in Receivables

This ratio tells us how many days there is a gap between the billing of the company and the receipt of money from it. This shows the efficiency of the collection department of the company. The sooner the company collects the money, the sooner it will be able to invest that money in something else.

The formula to calculate this is:

Days Sales Outstanding = 365 / Receivables Turnover Ratio

Let’s work it out for ARBL:

= 365 / 8.24

= 44.29 days

This means that ARBL is able to recover the money only after 45 days of raising the bill. 

It also shows the credit policy of the company. A good company has to strike a balance between credit policy and extending credit to its customers.

Main points of this chapter

  1. Leverage ratios include interest coverage, debt to equity, debt to assets, and financial leverage ratios. 
  2. The leverage ratio gives us information about the debt of the company. It tells how capable the company is of repaying its long-term debt or debt. 
  3. The interest coverage ratio shows the earning capacity of the company. This is shown at the level of EBIT, as compared to the finance cost. 
  4. The debt-to-equity ratio compares the equity capital and debt capital of the company. Debt to equity is 1 means that the equity and debt of the company are equal. 
  5. The debt-to-asset ratio tells us about the company’s asset financing (where the money is coming from to create assets), especially in terms of debt. 
  6. The financial leverage ratio tells us how much of a company’s assets are made up of owners’ equity. 
  7. The operating ratio is also called the activity ratio. It includes fixed asset turnover, working capital turnover, total asset turnover, inventory turnover, inventory number of days, receivable turnover, and days sales outstanding ratio. 
  8. The fixed asset turnover ratio tells how much the company is earning against the investment made in its fixed assets. 
  9. The working capital turnover ratio tells how much the company is earning against each unit of its working capital. 
  10. The total asset turnover ratio tells how much the company is earning from a given asset. 
  11. The inventory turnover ratio tells how often a company has to replenish its inventory. 
  12. The inventory Number of Days shows how quickly a company is able to convert its inventory into cash.
    1. A higher inventory turnover and a lower inventory number of days are good for the company. 
    2. But keep in mind that this should not be accompanied by a reduction in the production capacity of the company.
  13. The receivables turnover ratio tells how often a company receives cash from its debtors and customers in a given time period.
  14. The Days sales outstanding (DSO) ratio tells us about the company’s average cash collection period, i.e., the number of days between the time the company bills and collects the money.

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

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