Financial Ratios

Knowledge sharing!

Evaluating the financial health of an entity is something we all do from time to time. It can be for personal investment point of view or, from a work related point of view such as mergers, partnerships, investing etc.

Given that it is something we all use, it is better to have some idea/clarity about how to go about it. Here's my 2-cents on the topic based on my learnings...

Before we proceed ahead, there are a few things I would like to tell you about.

1. Financials are all relative. The should not be evaluated for a single entity from a particular industry. Evaluation should always be done by comparing the major players of the concerned industry with the entity under consideration.
2. Never take only 1 or 2 years of data for your evaluation. Data set used should have historical trends of at least 5 years.

Sites like moneycontrol.com , https://www.screener.in/ can help you with these aspects.

Okay. Let's get into it!

To analyse an entity, it is prudent to have the financial reports of the same. Financial reports as in, P&L statement, Balance Sheet, & Cash Flow statement. Once those are in place, which can be acquired from the companies official websites (if listed) or from www.mca.gov.in for unlisted firms.

There are many ratios that indicate the financial strength & standing of an entity in its domain/industry. The major ones to look out for are:

1. Gross Profit Ratio = (Gross Profit/Revenue)

Using the P&L statement, look for the entity's (Gross Profit/ Revenue) data & compare the same with industry leaders for at least 5 years. This will indicate how the company has been doing in terms of revenue, & COGS in the industry. The higher the better.

2. Liquid Ratio = (Current Assets/Current Liabilities)

Using the Balance Sheet, gauge whether the company has sufficient funds to pay of its current debts. Ideally, it should be 2:1. IDEALLY.

3. Return of Equity Ratio (ROE) = (PAT/Avg. Equity), you can also take DuPont analysis into account.

This is a ratio we hear the most where people discuss what is the expected return of the investment. Using P&L statement & Balance Sheet, you can track the ROE of the entity in comparison to the other major players. Another analysis that comes out of ROE is DuPont Analysis which is

Net Profit Ratio X Asset Turnover Ratio X Equity Multiplier

= (PAT/Sales) X (Sales/Total Avg. Assets) X (Total Avg. Assets/Total Avg. Equity)

This gives an exploded view of different parameters of the company.

4. Interest Coverage Ratio = (EBIT/Interest Paid)

Using P&L statement, we can find out the companies ability to pay loans/interests.

5. Operating Cycle Days = Inventory Turnover Days + Receivable Days - Payable Days

This parameter tell you about the number of days the company runs on its own money or shareholder's/supplier's money

Inventory TO days = 365/(COGS/Avg. Stock)

Receivable days = 365/(Credit Sales/Avg. Receivables)

Payable days = 365/(Credit Purchase/Avg. Payable)

6. P/E ratio = (Market Price per Share)/(PAT/Number of Shares)

This tells you about the value of the shares of the entity as on date.

From Cash Flow statement, look for the following:

1. Is Operating Cash Flow sufficient enough to take care of Investment Cash Flow?
2. Is Financing Cash Flow justified?
3. Is the cash being used for growth, loan repayment, or borrowings?

Happy & profitable investing!