Understanding Ratios.....!

By

Neerav Nagar
Lecturer (Finance)
St. Francis Institute of Management and Research
Mt. Poinsur, S.V.P. Road, Borivali (West), Mumbai-400 103
 

Often many of us try to fight with the numbers that appear in either the newspapers or the annual reports of various companies. However, we are always dealing with the absolute numbers and hence, the analysis of that company on stand alone basis or comparison with its peers is not possible.

Let me take an example. Recently one of the newspapers carried this information about the performance of the top 10 companies of India and China last year in terms of sales and profits:

This is where ratios come to our rescue. In this case, if we find a relationship between the Net Profit and Sales, we can observe that Chinese companies are earning a return of 13.89% [(40/288)*100] on their sales whereas Indian companies are earning a return of 7.82% on their sales. So, we can interpret that Chinese companies are earning Rs. 13.89 on every Rs. 100 of sales while the corresponding figure for the Indian companies is only Rs. 7.82.

In other words, Chinese companies are incurring a cost of Rs. 86.11 (100-13.89) for Rs. 100 of sales whereas the corresponding figure for the Indian companies stands at Rs. 92.18. This cost has been incurred with respect to the purchase of raw material, manufacturing, wages and other operating costs. This also proves that Chinese companies are relatively cost efficient as compared to their Indian counterparts which has been substantiated by various reports mentioning about China's emergence as an effective low cost destination for manufacturing and services.

We have been able to get this insight because of the use of ratios which establish relationship between two absolute numbers so as to enable us to make meaningful analysis and comparison.

There are various other ratios which we can use for our analysis, which are listed here along with their brief interpretation.

1. Liquidity ratios

a. Current ratio = Current Assets__
                        Current Liabilities

Indicates:

* Short term solvency of a firm
* Its ability to pay-off its Current Liabilities
* Rupee of Current Assets available for each rupee of Current Liabilities
* Should not be very high, as that may indicate that the funds are blocked in Current Assets which do not earn any return

b. Quick (Liquid) ratio =   Current Assets-Inventories
                                   Current Liabilities

Indicates:

* Short term solvency of a firm
* It is a comparatively rigorous test as huge amount may be blocked in inventories which may have inflated the current ratio
* Inventories are considered as the least liquid among the current assets

2. Profitability ratios

a. Gross Profit ratio = Gross Profit * 100
                              Sales

where,

Gross Profit = Sales – Cost of Goods Sold

* Higher Gross Profit ratio indicates lower Cost of Goods sold and vice-versa

b. Net Profit ratio = Profit after Tax * 100
                           Sales

* Higher Net Profit ratio indicates lower Cost of Good Sold, operating expenses like administrative, selling and distribution expenses and financing expenses and vice-versa

c. Return on Investment = Operating Profit * 100
                                    Total Assets
where,

Operating Profit = Gross Profit – Operating Expenses

Indicates:

* Profitability of investment made by creditors and shareholders
* Operating Profits are the profits available to pay interest, taxes and dividends

d. Return on Equity = Profit after Tax – Preference Dividend * 100
                                              Net Worth
where,

Net Worth = Equity Share Capital + Reserves and Surplus

Indicates:

* Whether equity shareholders are earning satisfactory return on their investment

3. Turnover ratios

a. Asset Turnover ratio = Sales * 100
                                    Total Assets

Indicates:

* Sales earned per rupee of investment
* Higher the ratio, more efficient the company is in utilizing its assets

b. Average Inventory Age (in months) = _____12________* Avg. Inventory
                                                    Cost of Goods Sold

where,

Avg. Inventory = Opening Inventory + Closing Inventory
                                             2

Indicates:

* How quickly inventory is disposed
* Lower the ratio, it is good as it indicates lesser amount of funds blocked in the inventory
* Excessive lower ratio may indicate underinvestment in the inventory which may result in not meeting customer demand

c. Average Collection Period (in months) =  _____12______* Avg. Debtors
                                                            Credit Sales
where,

Avg. Debtors = Opening Debtors + Closing Debtors
                                            2

Indicates:

* How quickly cash is received from the debtors for the good sold
* Lower the ratio, better the collection efforts and quality of debtors

d. Average Payment Period (in months) =  _____12______* Avg. Creditors
                                                        Credit Purchases

where,

Avg. Creditors = Opening Creditors + Closing Creditors
                                              2

Indicates:

* How quickly cash is paid to the creditors for the raw material purchased
* Lower the ratio, better the credit standing and reputation of the firm

4. Solvency ratios

a. Debt-Equity ratio = Total Debt
                                 Equity

Indicates:

* Higher the ratio, greater the dependence on the borrowed funds and greater the interest payments
* Implies higher risk for the lenders as the amount contributed by the equity shareholders is comparatively less

b. Interest Coverage ratio = Operating Profit
                                            Interest

Indicates:

* Higher the ratio, more are the profits available to pay interest to the lenders
* Excessive high ratio may indicate conservative approach of the firm by using equity which results in higher cost of capital

5. Other ratios

a. Earning per Share = Profit after Tax - Preference Dividend
                                  No. of Outstanding Equity Shares

Indicates:

* Profit available to the equity shareholders on each share

b. Price-Earning ratio = Market Price per Share
                                   Earning per Share

Indicates:

* Price which investors are ready to pay for every rupee of earning

c. Dividend Payout ratio = Dividend per Share * 100
                                  Earning per Share

Indicates:

* The percentage of earnings paid to the equity shareholders as dividends

d. Price to Book Value ratio = Market Price per Share
                                        Book Value per Share

where,

Book Value per Share = _________Net Worth________
                              No. of Outstanding Equity Shares

Indicates:

* Higher the ratio, better the growth prospects for the firm

All these ratios can help in carrying out an efficient analysis of a firm. However, it is always prudent to this comparative analysis for a particular firm for different years or for a particular year, with respect to its competitors within the industry. It will not be wise to compare the performance of two companies from different industries as there will be variations in their composition of assets and liabilities and cost structure because of the difference in their nature of business.
 

Neerav Nagar
Lecturer (Finance)
St. Francis Institute of Management and Research
Mt. Poinsur, S.V.P. Road, Borivali (West), Mumbai-400 103
 

Source: E-mail October 13, 2006

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