Meaning Of Ratio Analysis And Presentation Of Ratio

Concept And Meaning Of Ratio Analysis

Financial statement analysis the process of analyzing financial statements of a company so as to
obtain meaningful information about its survival, stability, profitability, solvency and growth prospect.
The financial statement analysis can be performed by using a number of techniques such as
comparative statements, common size statements and ratio analysis. Ratio analysis is the most
popularly and widely used technique of financial statement analysis.

In a simple word, ratio is a quotient of two numerical variables, which shows the relationship
between the two figures. Accordingly, accounting ratio is a relationship between two numerical
variables obtained from financial statements such as income statements and balance sheet.
The income statement or profit and loss account shows the operating results in terms of net profit
or loss of a company for a specific period. The balance sheet, on the other hand, shows the financial
position of the company at the end of that period. Accounting ratios are used as an important tool of
analyzing the financial performance of the company over the years and its comparative position
among other companies in the industry.

Ratio analysis is the process of determining and interpreting numerical relationship between figures
of financial statements. Since an absolute accounting figure often often does not provide much
meaning by itself, it has to be analyze in relation to other figures so that significant information about
the company's financial performance can be derived.

Ratio analysis is a process of determining and presenting the quantitative relationship between two
accounting figures to evaluate the strengths and weakness of a business. It is important from the
point of view of investors, creditors and management for analysis and interpretation of a firm's
financial health.

Presentation Of Ratio
Ratio can be expressed in the following terms:

1. Ratio method
Ratio method shows the relationship between two figures in ratio or proportion. It is expressed by
simple division of one item by another eg. 2.5:1,0.5:1 and so on.

2. Rate method
This method shows relationship in rate or times, like 2 times or 4 times and so on.

3. Percentage method
The relationship between two figures can be presented in percentage like 20%, 30% and so on.

Classification Of Accounting Ratios

Accounting ratios can be classified from different point of view. Ratios may be used to evaluate the
company's liquidity, efficiency, leverage and profitability. The ratios may be classified as following.

1. Liquidity Ratios
a. Current Ratio
b. Quick Ratio

2. Leverage Ratios
a. Debt-equity ratio
b. Debt to total capital ratio

3. Turnover Ratios
a. Inventory turnover ratio
b. Debtors turnover ratio
c. Average collection period
d. Total assets turnover ratio
e. Fixed assets turnover ratio
f. Capital employed turnover ratio

4. Profitability Ratios
a. Profitability in relation to sales
b. Profitability in relation to investment
c. Profitability in terms of earnings and dividend

Nature Of Ratio Analysis

In financial analysis, ratio is used as an index of yardstick for evaluating the financial position and
performance of the firm. It is a technique of analysis and interpretation of financial statements. Ratio
analysis helps in making decisions as it helps establishing relationship between various ratios and
interpret thereon. Ratio analysis helps analysts to make quantitative judgement about the
financialposition and performance of the firm. Ratio analysis involves following steps:

1. Relevant data selection from the financial statements related to the objectives of the analysis.

2. Calculation of required ratios from the data and presenting them either in pure ratio form or
in percentage.

3. Comparison of derived different ratios with:

i. The ratio of the same concern over a period of years to know upward or downward trend or static
position to help in estimating the future, or
ii. The ratios of another firm in same line, or
iii. The ratios of projected financial statements, or
iv. The ratios of industry average, or
v. The predetermined standards, or
vi. The ratios between the departments of the same concern assessing either the financial position
or the profitability or both.

4. Interpretation of the ratio

Ratio analysis uses financial report and data and summarizes the key relationship in order to
appraise financial performance. The effectiveness will be greatly improved when trends are
identified, comparative ratios are available and inter-related ratios are prepared.

Importance And Advantages Of Ratio Analysis

Ratio analysis is an important tool for analyzing the company's financial performance. The following
are the important advantages of the accounting ratios.

1. Analyzing Financial Statements

Ratio analysis is an important technique of financial statement analysis. Accounting ratios are
useful for understanding the financial position of the company. Different users such as
investors, management. bankers and creditors use the ratio to analyze the financial situation of the
company for their decision making purpose.

2. Judging Efficiency
Accounting ratios are important for judging the company's efficiency in terms of its operations and
management. They help judge how well the company has been able to utilize its assets and earn
profits.
3. Locating Weakness
Accounting ratios can also be used in locating weakness of the company's operations even though
its overall performance may be quite good. Management can then pay attention to the weakness
and take remedial measures to overcome them.

4. Formulating Plans
Although accounting ratios are used to analyze the company's past financial performance, they can
also be used to establish future trends of its financial performance. As a result, they help formulate
the company's future plans.

5. Comparing Performance
It is essential for a company to know how well it is performing over the years and as compared to the
other firms of the similar nature. Besides, it is also important to know how well its different divisions
are performing among themselves in different years. Ratio analysis facilitates such comparison.

Managerial Focus on Ratios

Stock investing requires careful analysis of financial data to find out the company's true worth.
This is generally done by examining the company's profit and loss account, balance sheet and
cash flow statement. This can be time-consuming and cumbersome. An easier way to find out
about a company's performance is to look at its financial ratios, most of which are freely
available on the internet.

Though this is not a foolproof method, it is a good way to run a fast check on a company's
health.

"Ratio analysis is crucial for investment decisions. It not only helps in knowing how the
company has been performing but also makes it easy for investors to compare companies in the
same industry and zero in on the best investment option," says DK Aggarwal, chairman and
managing director, SMC Investments and Advisors.
We bring you eleven financial ratios that one should look at before investing in a stock .

P/E RATIO
The price-to-earnings, or P/E, ratio shows how much stock investors are paying for each rupee of
earnings. It shows if the market is overvaluing or undervaluing the company.

One can know the ideal P/E ratio by comparing the current P/E with the company's historical
P/E, the average industry P/E and the market P/E. For instance, a company with a P/E of 15 may
seem expensive when compared to its historical P/E, but may be a good buy if the industry P/E is
18 and the market average is 20.

Sabyasachi Mukherjee, AVP and product head, IIFL, says, "A high P/E ratio may indicate that
the stock is overpriced. A stock with a low P/E may have greater potential for rising. P/E ratios
should be used in combination with other financial ratios for informed decisionmaking."

"P/E ratio is usually used to value mature and stable companies that earn profits. A high PE
indicates that the stock is either overvalued (with respect to history and/or peers) or the
company's earnings are expected to grow at a fast pace. But one must keep in mind that
companies can boost their P/E ratio by adding debt (thereby constricting equity capital). Also, as
future earnings estimates are subjective, it's better to use past earnings for calculating P/E ratios,"
says Vikas Gupta, executive vice president, Arthaveda Fund Management.

PRICE-TO-BOOK VALUE

The price-to-book value (P/BV) ratio is used to compare a company's market price to its book
value. Book value, in simple terms, is the amount that will remain if the company liquidates its
assets and repays all its liabilities.

P/BV ratio values shares of companies with large tangible assets on their balance sheets. A P/BV
ratio of less than one shows the stock is undervalued (value of assets on the company's books is
more than the value the market is assigning to the company). It indicates a company's inherent
value and is useful in valuing companies whose assets are mostly liquid, for instance, banks and
financial institutions.

DEBT-TO-EQUITY RATIO
It shows how much a company is leveraged, that is, how much debt is involved in the business
vis-a-vis promoters' capital (equity). A low figure is usually considered better. But it must not be
seen in isolation.

"If the company's returns are higher than its interest cost, the debt will enhance value. However,
if it is not, shareholders will lose," says Aggarwal of SMC.

"Also, a company with low debt-to-equity ratio can be assumed to have a lot of scope for
expansion due to more fund-raising options," he says.

But it is not that simple. "It is industry-specific with capital intensive industries such as
automobiles and manufacturing showing a higher figure than others. A high debt-to-equity ratio
may indicate unusual leverage and, hence, higher risk of credit default, though it could also
signal to the market that the company has invested in many high-NPV projects," says Vikas
Gupta of Arthaveda Fund Management. NPV, or net present value, is the present value of future
cash flow.

OPERATING PROFIT MARGIN (OPM)

The OPM shows operational efficiency and pricing power. It is calculated by dividing operating
profit by net sales.

Aggarwal of SMC says, "Higher OPM shows efficiency in procuring raw materials and
converting them into finished products."

It measures the proportion of revenue that is left after meeting variable costs such as raw
materials and wages. The higher the margin, the better it is for investors.

While analysing a company, one must see whether its OPM has been rising over a period.
Investors should also compare OPMs of other companies in the same industry.

EV/EBITDA

Enterprise value (EV) by EBITDA is often used with the P/E ratio to value a company. EV is
market capitalisation plus debt minus cash. It gives a much more accurate takeover valuation
because it includes debt. This is the main advantage it has over the P/E ratio, which we saw can
be skewed by unusually large earnings driven by debt. EBITDA is earnings before interest, tax,
depreciation and amortisation.

This ratio is used to value companies that have taken a lot of debt. "The main advantage of
EV/EBITDA is that it can be used to evaluate companies with different levels of debt as it is
capital structure-neutral. A lower ratio indicates that a company is undervalued. It is important to
note that the ratio is high for fast-growing industries and low for industries that are growing
slowly," says Mukherjee of IIFL.

PRICE/EARNINGS GROWTH RATIO

The PEG ratio is used to know the relationship between the price of a stock, earnings per share
(EPS) and the company's growth.

Generally, a company that is growing fast has a higher P/E ratio. This may give an impression
that is overvalued. Thus, P/E ratio divided by the estimated growth rate shows if the high P/E
ratio is justified by the expected future growth rate. The result can be compared with that of
peers with different growth rates.

A PEG ratio of one signals that the stock is valued reasonably. A figure of less than one indicates
that the stock may be undervalued.

RETURN ON EQUITY

The ultimate aim of any investment is returns. Return on equity, or ROE, measures the return
that shareholders get from the business and overall earnings. It helps investors compare
profitability of companies in the same industry. A figure is always better. The ratio highlights the
capability of the management. ROE is net income divided by shareholder equity.

"ROE of 15-20% is generally considered good, though high-growth companies should have a
higher ROE. The main benefit comes when earnings are reinvested to generate a still higher
ROE, which in turn produces a higher growth rate. However, a rise in debt will also reflect in a
higher ROE, which should be carefully noted," says Mukherjee of IIFL.

"One would expect leveraged companies (such as those in capital intensive businesses) to exhibit
inflated ROEs as a major part of capital on which they generate returns is accounted for by debt,"
says Gupta of Arthaveda Fund Management.

INTEREST COVERAGE RATIO

It is earnings before interest and tax, or EBIT, divided by interest expense. It indicates how
solvent a business is and gives an idea about the number of interest payments the business can
service solely from operations.

One can also use EBITDA in place of EBIT to compare companies in sectors whose depreciation
and amortisation expenses differ a lot. Or, one can use earnings before interest but after tax if one
wants a more accurate idea about a company's solvency.

CURRENT RATIO

This shows the liquidity position, that is, how equipped is the company in meeting its short-term
obligations with short-term assets. A higher figure signals that the company's day-to-day
operations will not get affected by working capital issues. A current ratio of less than one is a
matter of concern.

The ratio can be calculated by dividing current assets with current liabilities. Current assets
include inventories and receivables.Sometimes companies find it difficult to convert inventory
into sales or receivables into cash. This may hit its ability to meet obligations. In such a case, the
investor may calculate the acid-test ratio, which is similar to the current ratio but with the
exception that it does not include inventory and receivables.

ASSET TURNOVER RATIO

It shows how efficiently the management is using assets to generate revenue. The higher the
ratio, the better it is, as it indicates that the company is generating more revenue per rupee spent
on the asset. Experts say the comparison should be made between companies in the same
industry. This is because the ratio may vary from industry to industry. In sectors such as power
and telecommunication , which are more asset-heavy, the asset turnover ratio is low, while in
sectors such as retail, it is high (as the asset base is small).

DIVIDEND YIELD

It is dividend per share divided by the share price. A higher figure signals that the company is
doing well. But one must be wary of penny stocks (that lack quality but have high dividend
yields) and companies benefiting from one-time gains or excess unused cash which they may use
to declare special dividends. Similarly, a low dividend yield may not always imply a bad
investment as companies (particularly at nascent or growth stages) may choose to reinvest all
their earnings so that shareholders earn good returns in the long term.

"A high dividend yield, however, could signify a good long-term investment as companies'
dividend policies are generally fixed in the long run," says Gupta.

While financial ratio analysis helps in assessing factors such as profitability, efficiency and risk,
added factors such as macro-economic situation, management quality and industry outlook
should also be studied in detail while investing in a stock.