The Hindu Business Line : Understanding ratio analysis

A quicker way to understand a company’s performance, rather than poring over pages of accounts, notes and schedules in the annual report is through ‘ratio analysis’. Ratios can be classified into profitability ratios, coverage, turnover and financial ratios. We’ll take a look at a few ratios, their relevance and significance.

Profitability/ Return on Investment ratio

We start with profitability rations, as profit is the foremost objective of any business. Are the operations efficient enough to generate profits? This is what banks/financial institutions and creditors are worried about. After all, their money can be repaid only when the company is able to generate income from its operations, is it not? Shareholders, too, are equally concerned about profitability, as it broadly indicates the likely return they can earn on their investments.

The profitability ratio is calculated as: Operating profit/capital employed x 100. Operating profit is the profit before interest and taxes (PBIT). Capital employed is share capital + reserve and surplus + long-term liabilities - (non-business assets + fictitious assets).

Suppose the return is 8 per cent, how will you know whether this is good or bad? As a thumb rule, if the company has borrowed funds at, say, 7 per cent, the ROI should be greater than 7 per cent for the business to be profitable.

Coverage ratios

The ROI will show if the company is profitable alright; but will the profits be enough to pay interest on loan or repay the amount? This is where the ‘fixed interest cover’ and ‘debt service coverage’ (DSCR) ratios come in. Calculated as PBIT/ Interest charges, the higher the fixed interest cover, the better. A comfortable interest cover would be at least two-three times.

To find out whether a company can repay the principal portion of its loan on time, the DSCR is calculated — the formula being, PBIT/interest + (principal payment instalment / (1 – tax rate)). A DSCR of over 1 is considered appropriate. But here again, the higher the coverage, the better.

Turnover ratios

While the ROI is one indicator of profitability, the speed at which capital employed in the business rotates or is unlocked, is another. The higher the rotation, the greater the profitability. The ‘fixed assets turnover’ ratio (net sales/ net fixed assets) shows how much of the investment in fixed assets contribute towards sales. Ditto with the working capital ratios. High volume of sales with a relatively low working capital is an indicator of efficiency.

Credit sales/average accounts receivable will give the debtors turnover ratio. Say the turnover is three times, using this, we can calculate the collection period (months in a year/debtor’s turnover) as 12 / 3 = 4 months. This collection period indicates the promptness or the lack of it in money collection. Generally, the receivables should not exceed three-four months of credit sales. Such calculations can also be made for creditors. Similarly, a high inventory turnover (cost of goods sold/average inventory) ratio indicates good sales. A low ratio, in turn, indicates that money is locked up in stocks. The working capital ratios are useful in determining the company’s ability to generate future cash flows from operations.

Financial ratios

Liquidity and debt-equity ratios are widely used financial ratios. Liquidity ratio, also called the ‘short-term solvency’ ratio shows the adequacy or otherwise of working capital for a company’s day-to-day operations. It is calculated as current assets/current liabilities. An ideal current ratio would be 2, indicating that even if the current assets are to be reduced by half, the creditors will be able to able to get their money in full.

But a lot depends on the composition of current assets. If a substantial portion of the current assets is made of slow-moving/obsolete stocks or if the debtors comprise ageing debts, the company may not be able to pay the creditors even if the current ratio is higher than 2.

The debt-equity ratio is calculated as total long-term debt/shareholders’ funds. It is considered ideal if the ratio is 1. This ratio shows the extent of owners’ stake in the business as also the extent to which firm depends upon outsiders for existence.

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