In this section, we are going to discuss about financial ratios.
Financial ratios are very commonly used when doing financial analysis, and it is often used to describe
a company's performance and the situation the company is in, which is why when we use financial issues,
we also say that we are doing descriptive analysis of the company.
That is, we cannot use financial ratios to predict how the company will do in the future.
But we can answer questions on how the company performed and the history and what is the situation currently.
This is the reason investors look at financial ratios to understand companies strength, and we also
see these ratios commonly used in company, report investor presentations, etc..
So in this section, we will briefly cover what all these financial ratios mean, and we will also see
how to calculate them in Excel.
Please note that the list of ratios or how those ratios will be calculated, those are not fixed by
any authority or anybody.
The reason that I'm showing you here and there categorization that formula, all of these are based
on general acceptance, that is the ratio that I will show you.
That formula is generally accepted across all the companies.
However, from book to book or coast to coast, the definition of these ratios, the categorization
may differ, but the concept and understanding will remain the same, and that is what is more important.
So we are categorizing the issues into four different categories.
The first will be profitability ratios.
Second is liquidity ratios towards debt management ratios and important asset management ratios.
So let's begin discussing profitability ritual's.
The first profitability issue we are going to discuss is gross profit margin, this ratio indicates
the percentage of revenue which is available to cover operating costs and other expenses.
The formula is very simple, it is just the ratio of gross profit of the company divided by the total
sales revenue of the company.
Here we calculate gross profit by subtracting cost of goods sold from the total sales.
So we are only removing the input materials cost and we are trying to gauge what percentage of revenue
is available to cover all the other expenses.
Next is net profit margin.
This is simply the ratio of net profit after tax with the total revenue that the business made.
This means that this is the percentage of revenue which the owners can get as a return from the business.
As a general rule, a company with higher net profit margin than its competitors is considered a better
investment opportunity by the investors.
Today's return on assets.
Return on assets measure the return earned by the company on its asset.
The higher this ratio, the more income is generated by a given level of assets employed by the company.
The formula is this net profit plus.
Tax adjusted interest divided by the total assets.
Notice that there is one additional term in the numerator here, which is tax adjusted interest.
We are adding this because when we are calculating our way, we are measuring the return of all the
assets in the company, regardless of whether they were financed by loans or debt or equity or whatever.
For example, suppose a person he sets up a machine worth a hundred dollars using his own money and
earns ten dollars from the product created from that machine.
Then return on asset and the situation is 10 percent.
That is ten dollars divided by hundred dollars, which comes out of it 10 percent.
Now, if person B does the same thing.
But to finance the machine, he takes a loan of hundred dollars.
And at the end of the year, he pays ten dollars as interest amount.
In this case, also will take the return of ten dollars and we will not subtract the interest payment
from it to calculate the net profit, because this asset, even though it was financed by a loan, it
is still giving us a return of ten dollars.
So the return on asset of the same machine will still be the same.
Then the fort ratio is return on equity.
Which measures the return owned by a company on its equity capital.
Return is again, net profit, and the denominator here will be total equity.
Generally higher the ROIC compared to the competitors in the industry, the better investment option
it is for the investors.
Next, our liquidity issues.
Liquidity is basically quickly available money.
It is very important for a company.
If a company has good liquidity, it gives confidence to the lenders that the company will be able to
pay its obligations.
There are three issues that we discuss it.
The first is current racial.
Current ratio is simply the ratio of current assets with current liabilities, that is, we are checking
whether the claims that the company has to pay vs. the amount that will be available with the company
in the current period.
In current assets, we consider all form of cash or any such asset that will be converted to cash during
the current period.
Autocorrelation, let's look at quick racial.
Quickly issue is also known as acid test.
And it is a more stringent test of liquidity.
Because in this ratio, we do not include current assets such as inventory.
We only consider the quake assets such as cash or assets, which can be converted to cash quickly,
such as marketable securities and receivables.
So in quick ratio we take three things in the numerator cash, marketable securities and the receivables.
Denominator remains the same compared to quick ratio, cash ratio is even more stringent here.
We even do not consider the receivables.
So this cash plus marketable securities, these are the most liquid funds available to the company.
And we just compare that.
Will this most liquid fund be available to cover the current liabilities of the company or not?
The next set of ratios are for debt management.
So a company raises funds or capital mainly to raise.
Either people invest in it as equity or the business takes a loan or debt.
The balance between these two models of raising capital is often seen to assess the financial risk in
that particular company.
The first official we have here is debt to capital ratio.
This initial measures, the percentage of companies capital represented by date.
A higher ratio generally means higher leverage and higher financial risk.
Similar to this issue is debt to equity.
We're.
And the denominator, instead of considering debt plus equity, we will consider only equity.
A ratio of one here would indicate equal amount of debt and equity in that company.
The third issue here is interest coverage ratio.
These racial measures, the number of times accompanies bit, that is earnings before interest and taxes.
How many times this value can cover its interest payments?
For example, if a company has a value of a hundred thousand dollars and has to pay interest of ten
thousand dollars.
Each year, then the interest coverage ratio will come out to 10.
Such values of interest coverage ratios indicate stronger solvency.
Which gives greater assurance that the company could service its debt from the operating earnings.
So the lenders will be more confident in giving loans or debt to such companies with stronger interest
coverage ratio.
The last of the issues we look at are asset management ratios.
The first here is as a turnover ratio, which is simply the ratio of total revenue earned by the company
and the net asset employed by the company.
So this is basically giving us the efficiency at which the company is using its assets.
If you compare the same number of asset turnover ratio with the competitors of the company, you can
judge which company is performing more efficiently in the same industry.
When you are comparing industries, a lower ratio can indicate that that particular industry or business
is more capitaland into.
Or a low asset turnover ratio can also suggest that the business is not yet operating at full capacity.
The next issue is inventory turnover ratio.
This ratio measures how many times in a period the inventory sells out.
The formula for this issue is cost of goods sold, divided by average inventory balance.
For example, if you sell goods worth hundred thousand dollars and you maintain an average inventory
balance of 20000 thousand dollars, your inventory is replaced five times.
So if your inventory turnover ratio is high, it means that the inventory is held for shorter periods
of time.
You can also convert this ratio into number of days, so if you have inventory turnover ratio, you
can find out inventory days using the third formula, which is inventory.
This is equal to number of days in a period divided by inventory turnover.
So if our inventory turnover came out to be five, so within one year, our inventory gets down five
times.
Which means that in nearly 72 days.
Our entire inventory is a new.
Generally, we believe that lower the inventory is, the better it is, however, this value varies
from industry to industry, and it is better to compare inventory days between competitors of the same
industry and not from one industry to another industry.
So these are the four categories of issues that we will be now calculating in our Excel sheet.
You can find more such financial issues, depending on the kind of analysis that you are doing, and
there are several ratios created by several orders which are useful for a particular kind of analysis.
You can also create your own ritual for your own analysis and business purposes.
These are generally accepted, ratio's and categorisations, you may find differences in the formulas
and categorization of the issues also.
However, I hope that you get the concept and what are the kind of insight we try to derive from these
ratios?
Now, let us go to Excel and try to calculate these ratios for a set of balance sheets and profit and
loss statement.