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Ratio Analysis and Basic Valuation


Standard P&L
Gross Sales
Net Sales
Gross Profit
-Operating expenses (SG&A) excluding Depreciation
Operating Profit (EBIT) (EBITDA-D = EBIT)
-Extra-ordinary incomes / loss
Profit before tax (EBIT-I = EBT)
Profit After Tax

Types of Ratios
Profitability : to check the margins for the

firm and also for investors

Liquidity : to check how well the company
is able to pay its short term liabilities
Efficiency : to check how efficiently the
company manages its operations
Solvency : to check whether the company
is financially sound enough to meet its
long term liabilities

Profitability Ratios
Gross profit Margin
EBIT Margin
PAT Margin
Return on Investment
Return on Equity
Earnings per share
Dividend per share

Gross Profit Margin

Used to analyze how efficiently a company is

using its raw materials, labor and

manufacturing-related fixed assets to generate
Industry characteristics of raw material costs
have a major effect on a company's gross

EBITDA=Revenue-Expenses(Excl Interest Tax

Depreciation and Amortization)

Excludes non cash expenses like depreciation
and amortization
It nullifies the Financing and the differences in
depreciation related provisions
It is an appropriate metric to compare
companies from different countries
Note: EBITDA can be used as proxy for CFO

Operating(EBIT) Margin
Operating Profit / EBIT
EBIT=Revenue-Expenses(Excl Interest Tax)
By excluding both taxes and interest expenses,

it removes the effects of the different capital

structures and tax rates and thus makes for
easier cross-company comparisons.
Operating income figure is often the preferred
by investment analysts, versus net profit figure,
for making inter-company comparisons.

PAT Margin
The bottom line is the most often mentioned

when discussing a company's profitability.

There are several income and expense
operating elements that determine a net profit
Investors should take a comprehensive look at a
company's profit margins on a systematic basis.

Return on Equity
Net Income
Shareholders equity
Indicates how profitable a company is by

comparing its net income to its average

shareholders' equity.
Disproportionate amount of debt would
translate into a smaller equity base. Thus, a
small amount of net income (the numerator)
could still produce a high ROE off a modest
equity base (the denominator).

Return on Investments/Return on
Capital Employed
Total Assets-Current Liabilities
Should be higher than the rateat whichthe company

borrows, otherwise any increase in borrowing will

reduce shareholders' earnings.
Total Assets Current Liabilities is your

Capital Employed
Capital Employed is also equal to Total

Equity + Long Term Debt

Earnings Per Share

PAT - Preference Dividend
Number of Equity
Portion of a company's profit allocated to

each outstanding share of common stock

Should not be compared with other

Dividends Per Share

Dividend paid to Equity
Number of Equity Shares
Having a growing dividend per sharecan

bea sign that the company's management

believes that the growth can be sustained.
Dividend distribution depends on the

growth prospects of the company

Liquidity Ratios

Current Ratio
Quick ratio
Cash ratio

Current Ratio

Ascertain whether a company's short-term

assets are readily available to pay off its

short-term liabilities.
In theory, the higher the better.
Try to understand the types of current
assets the company has and how quickly
these can be converted into cash to meet
current liabilities

Quick Ratio

More conservative as it excludes inventory

and other current assets, which are more

difficult to turn into cash.

Efficiency Ratios

Ratios that are typically used to analyze how well a company

utilises and manages its assets and liabilities internally.

Improvement in the efficiency ratios usually translate to improved

profitability and cash flow

Debtors Turnover Ratio

Creditor Turnover Ratio
Inventory Turnover Ratio
Fixed Asset Turnover Ratio
Working Capital Turnover
Total Asset Turnover Ratio

Debtors Turnover Ratio


Net Average Debtors

Also called Accounts Receivables Ratio

Receivables turnover looks at how fast we collect

on our sales or, on average, how many times each
year we clean up or totally collect our accounts
Higher the debtors turnover ratio better it is.
Higher turnover signifies speedy and effective
Lower turnover indicates sluggish and inefficient
collection leading to the doubts that receivables
might contain significant doubtful debts

Credit to the customers is a necessary evil

Average Collection Period = Days in an Year/

Month in an Year
Debtors Turnover Ratio
Average collection period is also called Days' Sales
Outstanding (DSO)

Receivables collection period is expressed in number

of days.
It should be compared with the period of credit
allowed by the management to the customers as a
matter of policy.
Such comparison will help to decide whether
receivables collection management is efficient or

Why is it important?
The sooner the firm receives the payment, the sooner the firm

can start putting that money to use e.g. to reduce an overdraft

The longer the debt is owed, the more likely it will become a bad

How should it be evaluated?

- Against a standard for the market in which the firm operates

- The trend over time
- Compare with the equivalent ratio for payment to creditors

Firms can reduce debtor days by.

Insisting on cash payment
Offering shorter credit periods
Introducing penalties for late payment
Giving an incentive for prompt payment
But there are dangers:

- Chasing debtors leads to loss of goodwill

- Customers may choose firms which allow a long payment

Creditors Turnover Ratio

Average Creditors
Also called Accounts Payable Ratio

indicates the speed with which the

payments are made to the trade creditors

How does it compare with debtor days?

- Ideally this figure should be lower than the

debtor days figure
- If higher, it could result in cash flow problems

Average payment Period =

Days in an Year/ Month in an Year
Creditors Turnover Ratio
It measure the average number of days it takes a business to pay any money

owed to its suppliers

Shorter average payment period may have contradictory meaning:

- Business has a better liquidity position and hence repays the

amount quickly


- Or, Credit rating among the suppliers is not good and therefore they do not
allow reasonable period of credit

Inventory Turnover Ratio

Cost of Goods Sold
Average Inventory
Inventory turnover is a measure of the number of times
inventory is sold or used in a given time period
A low turnover implies poor sales and, therefore, excess

A high ratio implies either strong sales or ineffective buying
High inventory levels are unhealthy because they represent an

investment with a rate of return of zero. It also opens the

company up to trouble should prices begin to fall

Days' Sales in Inventory =

Inventory Turnover Ratio


The Days' Sales in Inventory ratio tells the business owner how many
days, on average, it takes to sell inventory
Lower the DSI is, the better, since it is better to have inventory sell

quickly than to have it sit on your shelves

Inventory turnover varies from industry to industry. Generally, a

lower number of days' sales in inventory is better than a higher

number of days
Businesses which trade in perishable goods have very higher

turnover with comparison to those dealing in durables e.g. Bakers


Why High Inventory Turnover ?

The purpose of increasing inventory turns is to reduce inventory

for three reasons.

- Increasing inventory turns reduces holding cost like rent,
utilities, insurance, theft etc.
- Reducing holding cost increases net income and profitability
- Items that turn over more quickly increase responsiveness to
changes in customer requirements while allowing the
replacement of obsolete items
A low turnover rate may point to overstocking, obsolescence, or

deficiencies in the product line or marketing effort

However, high turns may indicate that the inventory is too low

Working Capital Turnover Ratio

Working Capital
working capital = current assets - current liabilities
A company uses working capital to fund operations and purchase
inventory. These operations and inventory are then
converted into sales revenue for the company
The working capital turnover ratio measure the efficiency with

which the working capital is being used by a firm

A high ratio indicates efficient utilization of working capital and a

low ratio indicates otherwise

But a very high working capital turnover ratio may also mean lack

of sufficient working capital which is not a good situation

Fixed Assets Turnover Ratio

Total Fixed Assets

fixed-asset turnover ratio measures a

company's ability to generate net sales from fixedasset investments -specifically property, plant and
equipment (PP&E) - netof depreciation

A higher fixed-asset turnover ratio shows that the

company has been more effective in using the
investment in fixed assets to generate revenues.
The fixed asset turnover ratio is most useful in
manufacturing, where a large capital investment is
required in order to do business.

Total Assets Turnover Ratio

Total Assets
Asset turnoveris afinancial ratiothat measures the
efficiency of a company's use of itsassetsin
generating sales revenue to the company.
The total asset turnover ratio considers all assets
includingfixed assets, like plant and equipment, as
well asinventoryandaccounts receivables.
This ratio will vary by industry, as some industries are
more capital intensive than others.
The asset turnover ratio formula only looks at
revenues and not profits. This is the distinct
difference between return on assets (ROA) and

What could lower the total asset

turnover ratio?

The firm could be holding obsolete inventory and

not selling inventory fast enough.
With regard to accounts receivable, the firm's
collection period could be too long and credit
accounts may be on the books too long.
Fixed assets, such as plant and equipment, could be
sitting idle instead of being used to their full
Sales are not commensurate with the investment
i.e. the company is not utilizing its capacity.

Solvency Ratios
To find out whether the Company is
financially sound and can meet its
long-term obligations on the due

Debt- Equity Ratio

Long-term Debt

It indicates what proportion of equity and debt the company is using

to finance its assets

Ideally the cost of debt financing mustnot outweigh the return

thatthe companygenerates on the debt through investment and
business activities

A high debt/equity ratio generally means that a company has been

aggressive in financing its growth with debt.

This can result in volatile earnings as a result of the additional

interest expense
A ratio of 1:1 is usually considered to be satisfactory ratio although
there is no thumb rule

The interpretation of the ratio depends upon the financial and

business policy of the company

automanufacturing tend to have a debt/equity ratio above 2, while
software companies have a debt/equity of under 0.5

Interest Coverage Ratio


Interest on Long- term

Interest Coverage Ratio is also know as Debt service ratio

Interest coverage ratio (ICR)is a measure of a company's ability

to meet its interest payments.

It determines the number of times a company could make the

interest payments on its debt with itsEBIT

An interest coverage ratio below 1.0 indicates the business is

having difficulties generating the cash necessary to pay its
interest obligations (i.e. interest payments exceed its earnings)

The lower the interest coverage ratio, the higher the

company's debt burden and the greater the possibility
ofbankruptcyor default.

A higher ratio indicates a better financial health as it means that

the company is more capable to meeting its interest obligations
from operating earnings.

Debt Service Coverage Ratio

Cash flows from operating activities after tax
Interest on Long- term Loans +Installments paid during the
year on long-term loans

It is also known as debt coverage ratio

It is the ratio of cash available for debt servicing to interest,

principal and lease payments

Debt service coverage ratio (DSCR) essentially calculates the

repayment capacity of a borrower.

DSCR less than 1 would meana negative cash flow and

inability of firms profits to serve its debts

Whereas a DSCR greater than 1 means not only serving the

debt obligations but also the ability to pay the dividends

DSCR is calculated when a company / firm takes loan from

bank / financial institution / any other loan provider. The higher

Valuation Methodologies

Valuation Multiples
Price to Earning Ratio:

Market Price Per Share/ Normalized Earning Per

There are two types of P/E ratios:
1. Historical: Based on the previous year/quarters earning per
2. Forward: Based on expected i.e. estimated earning per share
. The P/E ratio is most appropriate in the valuation of
companies that have relatively stable earnings .
. Such companies can be found in sectors where prices and
demand are relatively stable, such as FMCG, Consumer
Durables, Pharmaceutical

Valuation Multiples
Price to Earning Growth Ratio:
PE Ratio/Growth Rate
This ratio is used to get a sense of how the market is
valuing a particular companys ability to grow, or its
future growth potential.
Type of Company:
This metric can be used across sectors (providing
they have earnings) but is most commonly used in
high growth industries (such as technology and

Valuation Multiples
Price to Sales Ratio(P/S):
Price per share/Sales per share
Without earnings, revenue projections can be a useful
tool in approximating the relative worth of a company
Type of Company: The metric is particularly useful in
the valuation of under-earners or companies without
any visible earnings, such as early stage technology
companies, or companies with high fixed costs
Limitation: This ratio is less appropriate for service
companies such as banks or insurers who do not

Valuation Multiples
Price to Book Value (P/S):

Price per share/Book Value Per Share

This ratio works well in the valuation of companies that have a
lot of hard assets, such as factories or oil reserves, or financial
assets such as loans.
Generally speaking, a book value of less than 1.0x would be an
indication of good value, as the market is assigning a value to
the company that is less than what you would get if you were to
sell the company and pay off all liabilities.
In the new economy, this particular metric does not work well,
as many companies have intangible assets, such as intellectual

Enterprise Value
Common equity atmarket value + (debt at
market value-cash and cash equivalents)
Enterprise Value
is equal to
total value
of the company, as it is
trading for on the stock market.

To compute it, add the market cap (see above) and the total net
debt of the company.

The total net debt is equal to total long and short term debt minus

The Enterprise Value is the best approximation of what a company

is worth at any point in time because it takes into account the
actual stock price instead of balance sheet prices.

Enterprise Value fluctuates rapidly based on stock price changes.

Most important multiple in M&A transactions: EV/EBITDA

Most Important Multiple?

1. It's useful for transnational comparisons because it ignores

the distorting effects of individual countries' taxation policies.
2. It's used to find attractive takeover candidates.
3. Enterprise value is a better metric than market cap for
4. It takes into account the debt which the acquirer will have to
5. Therefore, a company with a low enterprise multiple can be
Note: If EBITDA is negative one may
viewed as a good takeover candidate.
consider EV/Sales

Industry Multiples



Cyclical Manufacturing

P/E, Relative

Often with normalized earnings

High Tech, High Growth


Big differences in growth across


High Growth/No Earnings

P/S ,

Assume future margins will be good

Heavy Infrastructure

Firms in sector have losses in early

years and reported earnings can vary
depending on depreciation method

Financial Services


Book value often marked to market



If leverage is similar across firms



If leverage is different

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