The Hindu Business Line : Ratios to relate to

Don't curse yourself if you find it difficult to relate to financial statements. You aren't alone. Numbers daunt most of us; more so, the long columns that stare from annual accounts.

As a result, perceived complexity may beat any faint hopes of comprehension. A bigger hurdle is of comparison, of results, whether between periods or companies. To help relate better to numbers, what can help are relationships, or ratios. How? By putting the figures into perspective, says Raghu Palat in Understanding Financial Ratios in Business, from Jaico (www.jaicobooks.com).

"Ratios express a relationship between one figure and another," but the connection should be real. "For example, a ratio expressing the cost of sales as a percentage of investments is of no consequence as there is no commonality between the figures, whereas a ratio that expresses gross profit as a percentage of sales indicates the mark-up made on the cost of purchases or the margin earned by the company."

A chapter devoted to `margins' discusses ratios such as gross margin, operating margin, and so on. A measure of profitability that is better than pre-tax income is margin before interest, writes Palat. "Low margins are not necessarily bad. There are many large companies that cut prices to be more competitive and thereby increase sales. Businesses with very high sales usually have low margins."

The `profitability' discussion begins with ROTA, that is, return on total assets. The author cautions that since variations in asset and liability amounts during the year can distort the ratios materially, one should base the computations on average assets/liabilities.

Learn to measure ability to pay currently maturing financial obligations by calculating liquidity ratios. "The most common measure of liquidity is current ratio," says Palat. Since this ratio has a shortcoming — of not differentiating between the easily realisable current assets and the rest — you have the quick or acid test ratio.

Measure also `the time a company takes to convert goods that it has purchased to cash after paying for the same' by computing `net trade cycle'. Do you know how `defensive ratio' is calculated? Average daily cash expenditure for operating expenses upon firm's most liquid assets. This ratio indicates "the number of days a company could theoretically remain in business without additional sales or new loans (financing)."

Were you a creditor of a company, the ratios that you would most depend on will be those on `debt service capacity'. The foremost is `debt coverage', which reveals the time taken to repay short and long-term debt. Check if loans are repaid from operating income, rather than with funds realised by selling assets. Ratios to relate to!

What is the inference if this ratio, for example, is 0.108? The company would take 9.25 years to repay its borrowed loans from internally generated funds, reasons Palat.

`Asset management or efficiency' is the focus of a different chapter. Analysts study if the level of assets is reasonable. "If there are more assets than necessary, the interest expense would be high and profits lower than otherwise." In the opposite situation, operational efficiency takes a hit owing to fewer assets than required. Stock turnover, average collection period, fixed asset utilisation, and creditor ratio are a few of the rations that fall in this category. Go on then to `gearing' — which indicates `the level of financial risk that is being borne in addition to the business risk'. When the rate of profit exceeds the cost of borrowed funds, the highly geared company is more profitable, writes Palat.

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D. Murali

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