Monetrix Financial Ratios Compendium MDI Gurgaon

Financial Ratios
Monetrix Financial Ratios Compendium MDI Gurgaon

A few basic things:

 One ratio cannot be used for the analysis of the whole company and several of them have
to be looked at simultaneously to form the whole picture

 The ratios vary vastly across different industries. Also, for the purpose of financial
analysis, ratios cannot be looked at in isolation, therefore they must be compared to the
ratios of their peer companies (cross sectional analysis) as well as against its ratios in the
previous years (time series analysis) to get a fair idea about the company’s performance

There are majorly five different types of ratios. They are as follows:
 Liquidity ratios: These ratios provide information about the ability of the company to
meet its short-term obligations.
 Solvency ratios: Solvency ratios provide information about a company’s ability to meet
its long-term obligations. They also provide an information about the leverage of the
company. Therefore, these ratios are also referred to as the debt ratios (Leverage refers to
the use of borrowed money by a company to fund its operations)
 Activity ratios: These ratios give indication of how efficiently is a company using it
assets like inventory and fixed assets. These ratios are also referred to as turnover ratios.
 Profitability ratios: These ratios provide information on how well a company generates
profits from its sales, assets, capital etc.
 Valuation ratios: Valuation ratios are generally used to estimate the attractiveness of a
potential or an existing investment and get an idea of the company’s valuation in
comparison to its peer companies.

PROFITABILITY RATIOS

Profit Margins
Margins are the profit metric used as a percentage of the total sales. Thus

Margin = Profit Metric / Total Sales

The Profit metric used could be Gross Profit, EBITDA, EBIT, PBT or PAT, and the margin is
called the metric followed by the word “Margin”, for example:

Gross profit Margin = Gross profit / Total sales

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Net profit Margin = Net Profit / Total sales

Comparing the margins for competitors could give an idea of the relative performance of
companies and the differences in margins for a company are used to analyse how much money is
spent at what stage of the business.

Return on Assets
ROA = EBIT / Average Total Assets
Return on assets is an indicator of how profitable a company relative to its total assets.
Therefore, a higher ROA is generally considered good for a company. Here, note that a lot of
times, net income is used in the numerator instead of EBIT, however EBIT is used as it is
independent of the company’s Capital Structure (Whether it has been financed by Equity or
Debt) and the assets are employed for generation of EBIT, irrespective of whether they were
financed through debt or equity. Thus, ROA is a measure of how efficiently the company
manages its assets. Generally, a high Return on assets ratio is considered to be good for a
company.

Return on Capital Employed

ROCE = EBIT/ Average Capital employed
Where Capital Employed = Total Assets – Current Liabilities
Capital Employed may also be seen Equity + Non-Current Liability or as the total money the
company has raised through financing.

Similar to ROA, a high ratio for ROCE also, is generally considered better. Although both ROA
and ROCE convey similar information, ROCE is from the liability perspective as to how much
return a company gives per the amount of capital raised, whereas ROA is from the asset
perspective as to how well the company is using its assets.

Return on Invested Capital

ROIC = EBIT/ Invested Capital
 Monetrix Financial Ratios Compendium MDI Gurgaon

where Invested Capital is Capital Employed – Cash and Cash equivalents.

This is a further refinement of ROCE since the cash although is needed to buy assets needed to
generate profits, but in itself, sitting with the company as reserves, it isn’t generating any revenue
or profit for the company, thus makes sense to be removed from the Employed Capital.

NOTE: NOPAT (Net operating profit after tax) is sometimes used for ROA, ROCE and ROIC
calculations to account for tax payable directly on the operating profit. But even here, interest
expense is not reduced because the denominator contains assets financed from both debt and
equity and thus portion of the income contributed towards debt holders (ie interest) should not be
removed.

Return on Equity

ROE = Net Income/ Average shareholders Equity

ROE is a metric of how profitable it is to invest in the equity of a company.

Net income, instead of EBIT is used in the numerator for ROE, because Net Income is the value
that is given back to the shareholders through dividends paid or the increase in shareholder’s
equity through retained earnings. The interest and tax paid is removed from EBIT to arrive at Net
income for the ROE calculation. This is done as the interest payment and the taxes belongs to
the lender and the government respectively.
It is to be noted that two companies with the exactly same assets and performance may have very
different ROE if they have different capital structures. This can be better understood from a
DuPont analysis. (The DuPont analysis uses a number of different ratios that will be covered
further in the compendium, therefore you can come back to DuPont analysis after having read
the other ratios)

A DuPont analysis tells you what exactly are the drivers of your ROE. The above mentioned
formula of ROE can be broken down into the following three components:
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ROE = (Net income / Sales) * (Sales / Average total assets0 * (Average total assets / Average
equity)

Mathematically, if you multiply these three components, you will get Net income / Average
equity i.e. ROE as a result.

Looking at these components individually,

The first component i.e. (Net income / Sales) is actually the formula for net profit margin
The second component i.e. (Sales / Average total assets) is actually the formula for asset
turnover
The third component i.e. (average total assets/ average equity) is the leverage ratio

Thus, it can be deduced that a company’s ROE can be driven by either high profit margins or the
efficient use of its assets (asset turnover) or it can simply be the effect of high amount of debts
and low equity of a company (leverage ratio). Based on an understanding of where the ROE is
coming from, an analyst must make his judgements accordingly.
Monetrix Financial Ratios Compendium MDI Gurgaon

TURNOVER RATIOS

These usually imply how effectively you transform something that the business has to something
that the business generates from it (for example: sales from assets), or a balance sheet item to a
corresponding PnL item that the balance sheet item is ultimately used for. Usually the Balance
sheet items are the average of the opening and closing values for the period for which the PnL is
being considered.

Asset Turnover Ratio

In general the purpose of all the assets is to generate sales for the business. Thus

ATR = Sales/ Average Assets

A high ATR ratio is usually preferred for a company. It means that the company is more
efficiently generating sales from thee assets that it owns.

NOTE: This ratio has further application in the DuPont Analysis.

Cash Conversion Cycle and Operational Turnover Ratios:

Inventory turnover ratios

A business usually has inventories so that they can be consumed to be sold off as the final
product. The formula for Inventory turnover ratios is as follows:

Inventory Turnover Ratio = COGS / Average Inventory

This can be interpreted as the number of times the average inventory has to be restocked for all
the production in the year. Hence

Days Inventory Outstanding = 365 / (Inventory Turnover Ratio)

Monetrix Financial Ratios Compendium MDI Gurgaon

This can be interpreted as the number of days it takes from buying the raw material to selling the
produced goods. Thus, a lower DIO indicates inventory efficiency of the company and is
desirable.

Receivables turnover ratio

Receivables are usually owed by the customers to the business, and are a part of the sales by the
company.

Receivables turnover ratio = Sales/ Average Receivables

This ratio can be interpreted as how efficiently does a company collects receivables from the
credit that it has extended to its customers. This is mostly used in the form of DSO

Days Sales Outstanding (DSO) = 365/ (Receivables turnover ratio)

This is the number of days a company takes to collect revenue after a sale has been made. Due to
the high importance of cash in running a business, it’s best for the company to collect
outstanding receivables as quickly as possible and reinvest in the business, and thus a low DSO
is desirable and a high DSO could lead to cash flow problems for the company. However, it is to
be noted that that a very low DSO is also not considered very good, as it might indicate that the
company has a very strict credit policy and thus it might lose out on potential sales opportunities.

Trade Payables turnover ratio and DPO

Payables are usually to the suppliers of the business to purchase the raw material and other
things.

Trade Payables Turnover Ratio = Purchases / Average Payables

This is mostly used in the form of DPO

Days Payables Outstanding (DPO) = 365 / (Trade Payables turnover ratio)

This is the number of days the company on an average takes to pay its suppliers. A high DPO
could imply that the suppliers have trust in the company are willing to give it supplies on credit.
Another way to look at it could be that the company is having trouble paying its suppliers and is
taking very long.
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Cash Conversion Cycle

Usually a company acquires inventory on credit, which results in accounts payable. A company
can also sell products on credit, which results in accounts receivable. Cash, therefore, is not
involved until the company pays the accounts payable and collects the accounts receivable. So
the cash conversion cycle measures the time between the outlay of cash and the cash recovery
and measures the number of days each net input dollar is tied up in the production and sales
process before it is converted into cash.

It’s formula is given by

CCC = DIO + DSO – DPO

CCC is not looked usually at a standalone basis and it is seen as a pattern over the years or with
respect to its competitors, along with other ratios. But typically, a lower CCC is considered
healthier for a company and a higher CCC could indicate cash flow problems.

A negative cash flow basically means that the company has higher powers to dictate terms. This
could be due to the large size of the company in the market or the company could be the only
monopoly player. Taking a large fmcg as eg, (ITC) can have a -ve cash flow since it can demand
a higher credit period from its suppliers and in turn give lower credit to the customers. Also some
industries like the e-commerce

This is also known as the Operating Cycle.

MARKET AND VALUATION RATIOS

EPS:

EPS refers to the amount of net income that each shareholder is entitled to

EPS = Net Income / Average No. of Shares outstanding

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NOTE: Unlike several of the Market Ratios, EPS is independent of the market price of the share
and not to be confused with the dividends paid.

Dividend Payout Ratio and Retention Ratio:

The net income generated by a company can be utilized for 2 purposes. To pay cash rewards to
the shareholders or to invest back and grow the business. The portions of the Net Income given
to these 2 purposes are the Dividend Payout Ratio and Retention Ratio respectively. Thus
Dividend Payout Ratio = Total Dividends Paid/Net Income
Retention Ratio = (Net Income – Total Dividends Paid)/Net
Income
Note: Total Dividends Paid = Dividend given per share * #Shares, but given the financials of the
company, you can calculate the Total Dividends Paid by checking what part of the net income
has not been added to the retained earnings, ie Net Income – (Increase in the Retained Earnings
from opening to closing)

Price to Earnings Ratio

Often called the PE ratio, its formula is as its name suggests

PE Ratio = Price per share/EPS

The EPS taken is usually for the past year or TTM (Trailing Twelve Months)
This ratio is the price you pay in order to earn a dollar of earnings from the total earnings of the
company. A high PE ratio means that you have to pay more to earn every dollar of the
company’s earnings and thus it might indicate that the company is overvalued and similarly a
low PE ratio might indicate that a company is undervalued. So, normally you’d prefer a lower
PE, but this is a naïve evaluation and there are several things to be considered while evaluating a
share. Different industries have very different ranges of PE ratios and even within an industry,
the capital structure adversely changes the PE ratio. Note: For a better understanding of how
Capital Structure changes the PE ratio watch:
https://www.khanacademy.org/economics-finance-domain/core-finance/stock-
and-bonds/valuation-and-investing/v/p-e-conundrum
Monetrix Financial Ratios Compendium MDI Gurgaon

PEG Ratio
Price/Earnings-to-growth ratio considers the estimated growth of the company of the company.
The earnings in PE ratio are historical, but for PEG ratio, we consider the future estimates of
earnings for the coming year, thus the denominator is estimated EPS or TTM EPS * growth
estimate.
PEG Ratio = Share Price / (EPS * Growth)
This could give a better picture to compare 2 shares for investing purposes.

Price/Book Value Ratio

The Book Value of the equity is its value that is mentioned on the liabilities side in the Balance
Sheet, which can also be calculated as the difference of the total assets and the liabilities. The
Price part denotes what the market values this equity as. It can be calculated using the following
formula:

P/B ratio = (Market Capitalization/Book Value of Equity) OR (Share Price/Book Value

per share) where Market Capitalization = Share Price * #Shares

The P/B ratio is preferred rather than PE ratio in certain industries like banking because banking
business is dependent more on the market evaluation of the balance sheet rather than the book
values or in the IT or other industries where there is a significant amount of intangible assets
which cannot be included in the balance sheets.

EV/EBITDA

One major drawback of the PE ratio is its dependence on the capital structure of the firm, for
which EV/EBITDA is a better measure. Here, note that EBITDA is used in the denominator
instead of EBIT as the depreciation method adopted by different companies could be different
thus EBITDA is used as a more universal for the proxy for the operating profit. Being a market
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valuation ratio, the asset value corresponding to the operating profit has to be based on what the
market evaluates the company’s operating assets value to be. Thus Enterprise Value is defined as
the market value of operating assets
Enterprise Value = Market Value of Equity + Market Value of Liabilities – Cash
Reserves = Market Capitalization + Total Liabilities – Cash
Cash is excluded from the enterprise value as cash in itself does not lead to any generation of
EBITDA and it’s only when you buy other assets from the cash that the generate profits.
Thus the ratio is given by
EV/EBITDA = Enterprise Value/ EBITDA
The main advantage of this ratio over PE ratio is its inherent incorporation of the capital
structure.

Other Industry Specific Ratios:

Various other ratios are used for specific industries for example Price/Sales for retail industry or
EV/tonne for the cement industry.

Dividend Yield
A financial ratio that indicates how much a company pays out in dividends each year relative to
its share price. It is somewhat a measure of bang for your buck.
Dividend Yield = Annual Dividend per Share/Share Price
Yields for a current year are often estimated using the previous year’s dividend yield or by taking
the latest quarterly yield, multiplying by 4 (adjusting for seasonality) and dividing by the current
share price.

LIQUIDITY RATIOS

Liquidity has to do with a firm's assets and liabilities. In particular, liquidity looks at whether or
not a firm can pay its current liabilities with its current assets.

Following are the list of liquidity ratios -

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Current Ratio
The current ratio shows how many times over the firm can pay its current debt obligations from
its current assets. In general, current assets refers to those assets which will be utilized and hence
generate cash in 1 year and current liabilities refers to those liabilities that need to be paid within
1 year that is cash will be utilized. So, this ratio means how much current assets a firm has to
meet its current liabilities.

Current Ratio = Current Assets/Current Liabilities

Remarks - A current ratio of less than 1 indicates that the company may have problems meeting
its short-term obligations so a current ratio of more than 1 around 1.5-2.5 is safe. However, too
high current ratio is also not desirable because that would mean company is not using its current
assets efficiently – For instance, current ratio for Apple was recently around 10 or 12 because
they amassed a hoard of cash. But investors get impatient, saying, “We didn’t buy your stock to
let you tie up our money. Give it back to us.” And then they are in a position of paying
dividends.

Quick Ratio or acid ratio

The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well
the company can meet its short-term debt obligations without having to sell any of its inventory
to do so.

Inventory is the least liquid of all the current assets because you have to find a buyer for your
inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore,
firms want to be able to meet their short-term debt obligations without having to rely on selling
inventory.

Quick Ratio = Current Assets - Inventory/ Current Liabilities

Cash Ratio
The cash ratio is a further more stringent measure of the liquidity as compared to the current
ratio and the quick ratio. It measures the amount of cash, cash equivalents or invested funds there
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are in current assets to cover current liabilities. It only looks at the most liquid short-term assets
of the company, which are those that can be most easily be used to pay off current obligations. It
ignores inventory, prepaid expenses and receivables as there are no assurances that these two
accounts can be converted to cash in a timely matter to meet current liabilities. Between quick
ratio and cash ratio, the difference is that account receivables is not present in cash ratio unlike
quick ratio.

Cash Ratio = (Cash + Cash Equivalents) / (Current Liabilities)

Remarks - A cash ratio of 1.00 and above means that the business will be able to pay all its
current liabilities in immediate short term. Therefore, creditors usually prefer high cash ratio. But
businesses usually do not plan to keep their cash and cash equivalent at level with their current
liabilities because they can use a portion of idle cash to generate profits. This means that a
normal value of cash ratio is somewhere below 1.00. Also, it is not realistic for a company to
purposefully maintain high levels of cash assets to cover current liabilities. The reason being that
it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance
sheet, as this money could be returned to shareholders or used elsewhere to generate higher
returns.

DEBT RATIOS / SOLVENCY RATIOS

These ratios aim to highlight the amount of debt taken by a firm. In most cases, a high amount of
debt is not generally preferable, as higher debt means higher obligations to pay interest
payments, thus a higher financial risk. However, a higher debt is not always bad as long as the
company is using that debt to expand or optimize its business operations or make long term
investment which will generate revenue or reduce cost – for instance purchase/replace equipment
or buy land or buy plant. In general, debt means long term borrowings and other non-current
liabilities (not including provisions)

There are primarily 3 types of debt ratios:

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Debt to Assets ratios: This is the simplest ratio to measure the amount of debt. It means what
percentage of assets are being funded by debt

Debt Ratio = Total Debt / Total Assets

Generally, large well-established companies can push the liability component of their balance
sheet structure to higher percentages without getting into trouble.
 Monetrix Financial Ratios Compendium MDI Gurgaon

Debt to Equity Ratio: It is another way of representing the capital structure of the firm. This is a
measurement of how much lenders, creditors and obligors have committed to the company
versus what the shareholders have committed.

Debt/Equity = Total Debt/Shareholder’s Equity

In general, if your debt-to-equity ratio is too high, it’s a signal that your company may be in
financial distress and unable to pay your debtors. But if it’s too low, it’s a sign that your
company is over-relying on equity to finance your business, which can be costly and inefficient.

Remarks - The debt to equity ratio can be misleading at times. An example is when the equity of
a business contains a large proportion of preferred stock. In this case a dividend may be
mandated in the terms of the stock agreement. This in turn impacts the amount of available cash
flow to pay debt. Then the preferred stock has the characteristics of debt, rather than equity.

Financial Leverage: This is another way of type of debt ratio. It means how much assets is
funded by equity. Lower the leverage, the more is equity-funded asset.

Financial Leverage: Total Assets / Total Equity

So, if the ratio is high it means less equity has been used to fund total assets. Business companies
with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to
repay the debts, it might lead to difficulties in getting new lenders in future.
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Interest Coverage Ratio:

More the debt, higher will be the interest expense. That means the company has to have higher
EBIT to cover it.

ICR = EBIT(1-tax rate) / Interest Expense

This ratio shows how the ability of the company to meet its interest payments from its operating
income. The higher the ratio, the better position a company is in, to meet its interest obligations.
Using tax Rate in the numerator is optional as taking tax into account is a more conservative
approach – since tax will anyways will be deducted from the total income, so we remove the tax
component before calculating ICR. However, it is not necessary to remove tax but we have to
consistent with the formula. In most cases, the above formula is preferred. The formula for ICR
without taking the Tax rate into consideration is as follows:

ICR = EBIT / Interest Expense

Remarks: As a general rule of thumb, investors should not own a stock or bond that has an
interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is
having difficulties generating the cash necessary to pay its interest obligations.
For a company, in a situation where its sales decline and the there is a subsequent decrease in its
net income, a high interest obligation can be a cause of concern. An excessive decrease in the net
income would result in a sudden, and equally excessive, decline in the interest coverage ratio,
which should send up red flags for any conservative investor.