[This article comes in a series of articles written about the fundamental analysis]. People who are interested in long term investing in stocks knows about financial ratio analysis. If you have heard about terms like price to earning ratio, price to book value ratio etc, you know ratios.
But in this financial ratio analysis we will go beyond these usual ratios. Generally I do a detailed fundamental analysis of my stocks using my stock analysis worksheet. My worksheet calculates financial ratios of stocks and presents it systematically as a final report.
But no matter how systematic or beautiful looking is the report, if the end user is not able to make a meaning of it, it is not useful. Hence I though to prepare a comprehensive guide about how to interpret financial ratios to analyse a company.
To interpret the numbers in these three reports, it is essential for the reader to use financial ratios. These financial ratios in turn will present such insights about the company which otherwise is very difficult to comprehend.
- #A. Liquidity Check & Solvency Check.
- #B. Operating Performance Check.
- #C. Financial Risk Check.
- #D. Price-Valuation-Check.
Introduction: Financial Ratio Analysis
In the process of financial ratio analysis, what we are going to check? We are going to check a company’s business fundamentals based on four parameters. Those four parameters are listed below:
- A. Solvency & Liquidity Check: Liquidity ratio tells about how well placed is the company to pay-off its short term debts (like current liabilities). Solvency check tells about the ability of the company to continue running its operations for the long term (Read more).
- B. Operations Check: All products and services has to go through the company’s operations to reach the final sellable stage. These ratios check, how efficient and profitable is the company’s operations (Read more).
- C. Financial Risk Check: These are ratios which check, inherently how risky is the underlying business of the company. Additionally, these ratios also check how risky is its stock for the investors (Read more).
- D. Price Valuation Check: After we have done all the above 3 checks, suppose we found a good stock. So what? It will not make any sense if we do not go ahead and buy it. But we cannot buy stocks at any price. We must do price valuation check. We can get the idea about price valuation from these ratios (Read more).
These are four ratio categories we can utilize to do financial ratio analysis for a company. There are multiple ratios within each category which does the work of stock analysis. Checking all the ratios for a company is an exhaustive work. So it takes time.
To explain the matter more clearly I’ll show screenshots of my stock analysis worksheet to display each ratio more visually. Let’s start the financial ratio analysis with liquidity check.
#A. Liquidity Check
Liquidity measurement helps us to check the company’s ability to pay of its immediate loan dues. Not only loans, company must also clear its other current liabilities like vendor payments, utility bills, tax dues, salaries etc. What makes a company capable to pay these dues? It’s cash balance.
Let’s start with the liquidity check. This is what is checked in the following ratio analysis:
#A1. Current Ratio
Current ratio is a ratio between company’s current assets and current liability. The bigger is the ratio the better. Why? Because bigger number indicates that the company has more current assets for every rupee of its current liability. If current ratio is say 2.5, it means to pay current liability of Rs.1 crore, the company has Rs.2.5 Crore (=1×2.5) of current assets.
Current Ratio = Current Asset / Current Liability
But it is also essential to look at the quality of current asset (CA). What I mean by quality? Ability of the asset to quickly convert into cash.
- Suppose a company holds an investment in for of short term bonds which matures after 200 days. This is not a very liquid current asset.
- Suppose a majority portion of company’s current asset is in inventory base. It is also not easy to convert inventory to cash.
- There can be company’s which has huge pile of account receivables. If this value is only growing (faster than sales growth), then it must be investigated. There can be a case that the customers are not paying.
- The best form of current asset which can actually take care of current liability is cash in bank.
A quick way to check the current ratio trend of a company is look into the financial ratio sheet of my worksheet, or to check the balance sheet .
Just for example sake, check the current ratio trend line for an example stocks considering its last 10 years data. Ideally speaking we would like to see a gradually increasing trend line for our stocks.
#A2. Quick Ratio
As we have seen in #A1 above, it is also important to focus on quality of current assets to judge the liquidity level of a company. One way of being sure of the quality of current assets considered for evaluation is to remove the inventory component from the current assets numbers. This is what we call as quick ratio. In terms of formula, it looks like this:
Quick Ratio = (Current Assets – Inventory) / Current Liability
What are the problems of considering inventory in current asset estimates? Inventory is not liquid enough. Why? Main reasons could be as shown below:
- If the demand is less, some inventory may never get sold. They may remain idle and eventually will go out as scrap.
- It takes time for an inventory to get sold. Except for FMCG’s, for other items, it might takes weeks or months to convert an inventory into a sale invoice.
- Even when the product is sold, the payment (cash) will eventually come after the credit period is exhausted.
Hence for me, quick ratio is a much more reliable metric (than current ratio) for liquidity check of a company.
My worksheet shows the company’s quick ratio alongside current ratio. This also highlights how dependent is a company current assets on its inventory. If current ratio and quick ratio are similar, it means inventory dependency is small. This is a good signal.
Ideally, as an investor we would like to see a gradually increasing or consistent quick ratio. Below is an example of a company which is showing a decreasing quick ratio trend. It may be a signal of falling collection, and cash reserves of a company. Nevertheless, quick ratio above 1 is a healthy liquidity metric.
#A3. Cash Ratio
This is the most confirmed metric of liquidity check of a company. Why? Because it considers only cash and cash equivalents to check on company’s liquidity. Examples of cash equivalents can be deposits, T-bills, liquid funds, short term Government bonds etc. In terms of formula it looks like this:
Cash Ratio = Cash & Cash equivalents / Current Liabilities
For a company, if cash ratio is more than one, we can surely assume that the company’s liquidity is very sound. It is the ultimate test. Not many company can claim to enjoy the luxury of cash ratio being more than one.
Let’s shee such a company looks in my stock analysis worksheet’s ratio sheet and balance sheet.
Now let’s do the solvency check on the company.
#A. Solvency Check
It is a measure of company’s ability to pay-off all its debts (both long term and short term debts). Why it is important? Because if a company is not paying its loan dues, it will be ultimately forced to get bankrupt. So in order for a company not to reach such a situation, it must perform its due diligence on its solvency position.
The question that must be asked is, how solvent is the company in consideration? To answer this question we can use three useful financial metrics:
#A4. Current Debt to Inventory Ratio
A company cannot be solvent if it is not paying its current liabilities. This ratio compares the company’s current liabilities with its inventory levels. What is the logic of this comparison?
It is a way to tell that, how much of current inventory it must sell to pay-off all its current liabilities. In terms of formula, it looks like this:
= Current Liability / Total inventory
Let’s see how this solvency ratio looks on the ‘ratio sheet’ of my stock analysis worksheet.
Here we can see that for Mar’19, the ratio is showing as 2.4. It means, to clear its current liability, the company needs to sell 2.4 times its current inventory levels. This value looks high.
Even the last five year trend is showing an increase of the ratio from 1.69 to 2.4 levels. This may be a cause of worry for the investors.
#A5. Current Debt to Networth Ratio
There are few companies which do not have to maintain a lot of inventory. This is a characteristic of their business model. For such companies, the above ratio (#A4) may give unnecessarily high values. They may not be a correct indicator of solvency.
For such companies, use of current debt to networth ratio is better. In terms of formula, this ratio looks like below:
= Current Liability / Networth
In the above example, you can see that for Mar’19 the ratio is 0.28. But looking at this value in isolation will not help.
Please remember that by using this ratio we are only expressing the current liability levels of a company with respect to its networth.
It is important to study the trend. See the last 5/10 year trend. If the ratio is increasing or decreasing. You would like to see a decreasing trend.
It is also important to compare the current liability to networth ratio of the company with its competitors. It will give an even better insights about the the sector average for the debt levels as compared to networth..
#A6. Total Debt to Networth Ratio
Like in #A5 shown above, this ratio also highlights the level of total debt of a company relative to its networth. The lower is the ratio, better is the solvency level of the company.
In terms of formula, this ratio looks like below:
= Total Debt / Networth
Let’s see the components of this ratio in my worksheet’s ratio sheet and in the balance sheet report.
To get a better idea of company’s solvency being good or bad, it is important to compare the data with its competing companies. It will also be interesting to check the last 5 or 10 year trend to see if the ratio is rising or decreasing.
Please note that for a debt free company, this ratio will be zero.
#B. Operating Performance
First we will see those ratios which quantifies operating efficiency of a company. Why we need to know it? Because this is a way to judge if the company is rendering enough business or not.
What we mean by business? Sales, income, payment collection etc. We will see which financial ratios help us to quantify these metrics:
#B1. Fixed Asset Turnover Ratio
It is a measure of how efficiently a company uses its fixed assets to generates sales. Seeing a one year ratio will not be helpful here. To make more meaning out of it, one must try to establish a trend. How to do it? By plotting a pattern of past 5 or 10 years.
In terms of formula, fixed asset turnover ratio can be calculated as shown below:
= Net Sales / Average Fixed Asset
Please note that fixed asset turnover ratio for capital intensive business like oil and gas, steel, auto, cement will be low compared to companies of IT sector, services, trading etc.
Hence it is better to compare fixed asset turnover ratio of company with its competitors or the sector average. This will give an idea of the comparative efficiency of the company over its rivals.
#B2. Operating Cycle
Operating cycle is expressed in days. It indicates the time taken by the company to convert its inventory in sales, and sales into cash. This cycle includes the total time taken to effect sales and to collect payments from customers. The lower is the operating cycle more efficient is the company’s operations.
In terms of formula, it is expressed as below:= DIO + DSO
= Days Inventory Outstanding + Days Sales Outstanding
Op. Cycle = 365 * (Avg. Inventory + Avg. Ac Receivables) / COGS
= 365 * (Avg. Inventory + Avg. Ac Receivables) / COGS
The computation of operating cycle can be done by combining data from profit and loss accounts and balance sheet. In my stock analysis worksheet, the operating cycle calculation is done automatically, and is displayed in ratio sheet.
In the above example, you can see that the operating cycle for Mar’19 is showing as 442 days. It is an indication that the cash of the company is locked for 442 days (in raw material purchase, manufacturing, sales, and collection) before it comes back in form of payment received from customer.
#B3. Cash Conversion Cycle
Cash conversion cycle is same as operating cycle, but it also considers a very important parameter. This makes cash conversion cycle more effective than operating cycle. But before we understand cash conversion cycle, let’s know a small basic.
Suppose there is a company whose days inventory outstanding (DIO) is 437 days and days sales outstanding (DSO) as 9.44 days. It means, its operating cycle is 446.44 days (DIO+DSO). Here we are assuming that the company’s cash is stuck in production and sales proceed for 446.44 days, right?
But our assumption may be wrong. Hypothetically speaking, suppose the vendors of this company does not ask for payment before 447 days from the date of sale. What does it mean? The company buys the items from its vendor and then pays them after 447 days.
Within these 447 days, something very interesting is also happening. Within this period (446.44 days) the company is able to manufacture and sell its products and collect cash from customers. Means, the company’s money is not locked at all in operations. It pays its vendors only after it has collected from its customers.
What is the point? Though the operating cycle of the company is 446.44 days, but its money is not locked even for one day. In this case the company’s cash conversion cycle is -0.56 days (446.44 – 447).
In terms of formula, cash conversion cycle looks like this:= DIO + DSO – DPO
= Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
Cash Conv. Cycle = 365 * (Avg. Inventory + Avg. Ac Receivables – Avg. Ac Payables) / COGS
= 365 * (Avg. Inventory + Avg. Ac Receivables – Avg Ac Payables) / COGS
The computation of cash conversion cycle is done by my stock analysis worksheet automatically. The result is displayed in the ratio sheet as shown below:
Check the difference between operating cycle and cash conversion cycle for Mar’19 (442 – 365 = 77 days). This is symbolic of average number of days of credit (DPO) the company is getting from its vendors.
Hence, for a company to reduce its cash conversion cycle it can do three things:
- Speed-up the production process.
- Accept shorter credit payment terms from its customer.
- Give longer credit payment terms to its suppliers.
Now we will see few ratios which can define operating profitability of the business. These are few most referred financial ratios of a company. Generally, long term investors who do fundamental analysis of stocks, resort to these ratios.
#B4. Gross Margin
It provides a profitability check on the company’s ability to generate profit after sales, by considering only direct cost of manufacturing products, or rendering a service. No other costs including overhead costs are considered to compute gross margin.
In terms of formula gross margin looks like this:= (Net Sales – COGS) / Net Sales
= Gross Income / Net Sales
Generally speaking, gross margin is a characteristic of a sector as a whole. For example, an auto company will display a very different gross margin as compared to a company in IT space.
Why we must look at gross margin of a company if it is not considering all the costs involved in doing a business? Because it can give us a birds eye view of the company.
- If the company’s gross margin is above the sector average, it is a clear sign of competitive advantage.
- When gross margin is falling, it may be due to selling price pressure – indicating stiff competition. It may be also due to increasing cost of operations.
- Increasing gross margin trend is what we would like to see in a company. Again, it is a sign of efficient operations and competitive advantage.
Let’s see how gross margin looks in my worksheet’s ratio sheet and how it is calculated:
#B5. Operating Profit Margin
Operating profit is that money which remains in the hand of the company after considering all operating expenses.
It is different from gross profit because some additional expenses are considered here. Expenses like depreciation, selling & administrative expense, other expense are considered to compute operating profit.
In terms of formula, operating profit looks like shown below:= (Gross Income – Operating Expense) / Net Sales
= Operating Profit / Net Sales
[P.Note: both gross profit and operating profit are metrics which highlights the profit making capability of the core business (operation). “Other income” sources are not accounted for in its calculation. Where as in PBDIT calculation “other income” is also considered along with net sales]
#B6. Net Profit Margin
We also refer “net profit margin” as Profit After Tax (PAT) Margin. In its computation “all income” and “all expenses” are considered. “All expenses” includes, taxes, interest, depreciation, selling & admin expenses, operating expenses etc. All income means Net Sales + Other income.
Net Profit (PAT) is the most followed financial metric of any company. In a way it highlight what’s left in the hand of the owners/shareholders of the company after accounting for all expenses. Read: About free cash flow.
It is important to note that net profit margin varies from sector to sector. Companies operating in IT sector will have a higher net profit margin than capital intensive companies like Oil & Gas, Steel, Auto, Cement etc. Hence if you want to compare PAT Margin between two companies, preferably do it within its sector.
Formula for Net Profit Margin will look like this:= [PBDIT – Depreciation – Interest – Taxes] / Total Income
= Net Profit / Total Income
For investors, it is good idea to keep track of the trend followed by Gross Margin, Operating Margin and Net Profit Margin of a company. It will clearly show where the company is likely to head in coming years. We would like to see a consistent or a growing margin trend instead of a falling trend.
#B7. Return on Asset (ROA)
Before we go ahead and read about what is ROA and how it is calculated, let’s first understand its context. Suppose you want to open a machine shop as your business. You have Rs.10 crore to set up the business.
What you will have to do? You will buy/lease a land, set-up plant and equipments & furnitures, hire people etc. What you are actually doing here? You are setting up an asset base of the company which in turn will produce and render goods and services for the customers. These goods and services in turn will yield sales and net profit.
Let’s understand another analogy. Suppose you have two options of starting the business. One in Mumbai and other in Kolkata. You have analyzed the market, and have found that following are income vs cost projections of the two alternatives.
- Asset Cost: Rs.9 Crore.
- Projected Net Income: Rs.0.73 Crore/year
- Asset Cost: Rs.5.8 Crore.
- Projected Net Income: Rs.0.46 Crore/year
How much profit is generated per unit asset cost in the two cities? In Mumbai the profit yield is 8.1% ( =0.73/9), and in Kolkata it is 7.9% ( =0.46/5.8).
What you can understand from this example? Though the cost of setting up the business in Mumbai is higher than Kolkata, but it also has potential to yield higher profits. Hence in terms of business set-up, Mumbai will be a better option to go for.
We have concluded this by doing the ROA calculation for Mumbai and Kolkata’s facility. Now let’s see how ROA is calculated in terms of Formula:
= Net Profit / Total Asset
ROA is a very important metric to judge the overall profitability of a business. It becomes particularly important for startups who plan to start a business. Asset vs profit analysis of several business alternatives will give good insights.
#B8. Return on Equity (ROE)
Equity is a portion of total asset. Another way to look at total asset of a company is through this formula (Total Asset = Equity + Debt). It depicts the total capital that the company has put to use (as on date) to do its business.
Out of this total capital, a portion is equity (shareholders money) and balance is borrowing. In ROA calculation we are considering the total capital put to use to derive company’s profitability.
But in ROE, we consider only the equity portion. Why? Because this metric (ROE) will highlight how profitably the company is using shareholders money to yield net profits.
High ROE or improving ROE is a symbolic of higher shareholders returns. Formula for ROE is shown below:= Net Profit / (Equity Capital + Reserves)
= Net Profit / Total Equity
#B9. Return on Capital Employed (RoCE)
This is one of those profitability ratios that is perhaps the most effective ones of all. It actually nails the concept of doing business. It defines how much returns a business is able to yield per unit capital it consumed.
Here we are not talking about “Total Asset” of the company. Here what is considered is called “Employed Capital”. What is employed capital? In terms of formula it looks like this:
Employed Capital = Total Assets – Current Liability
Employed capital is that portion of total asset which is locked for long term growth of the company. This is the portion of total asset which is actually contribution to yield long term benefits.
Why current liability is not a part of employed capital? Because this is that portion of the total capital which is already booked to meet the current needs of the company.
Here it is assumed that this money (equivalent to current liability) either stays idle in company’s bank account or locked in short term instruments. Hence we can say that this money is actually not employed. They do nothing for the company. They are just waiting to be paid to the suppliers, bills, salaries etc.
The formula of Return of Capital Employed looks like this:
= PBIT / (Total Asset – Current Liability)
#C. Financial Risk Check
Generally, companies take debt to manage the requirement of its business. These requirements can be of current in nature, like working capital management, and it can also be of long term in nature like funding Capex etc.
Though availability of debt helps the company to manage its capital needs but it also enhances its risk of doing the business. What is the risk? Debt is such an obligation of a company which if not paid back, may make a company to declare bankruptcy.
When a company goes bankrupt, it not only hurts the company but also its investors. The market value of the company’s shares goes down. This really hurts all the stakeholders.
Hence from the point of view of investors, it is better to analyze a company based on its ability to handle financial risk. There are few financial ratios available using which we can analyse if the company is using too much debt.
#C1. Debt Equity Ratio
Here the company’s debt level is analyzed with reference to its equity base. Suppose the sector average says, total debt of the company must not be more than 1.5 times its equity base. Now, if a company in this sector shows a debt equity ratio of more than 2.0, it is an indication that this company is more risky.
In terms of formula, debt equity ratio looks like this:
= Total Debt / Equity
#C2. Interest Coverage Ratio
When a company goes bankrupt? When it is unable to to pay even the interest portion of the debt. It is a situation where even the minimum payable amount is not paid for a period of more than 90 days. Bank declare such loan as NPA.
This is when the legal team of the bank takes over and the onward proceeding starts. This step may eventually force the company to declare itself bankrupt and can eventually lead to liquidation of its assets.
As an investor we can check if the company is nearing its bankruptcy threat. We can do it using a financial ratio called interest coverage ratio. It is a measure of company’s ability to pay at least the interest portion of its loan dues.
How a company will pay its interest dues? When it is making enough profits? How much profit is enough? When PBIT to Interest ratio (Interest Coverage Ratio) is at least more than 1. In terms of formula, interest coverage ratio looks like this:
= PBIT / Interest
#D Price Valuation Check
Price valuation ratios are those metrics using which we can judge if a stock is overpriced or underpriced. A good stock trading at undervalued price levels is what we should seek as an investor.
How to value price of shares? We can use four main fundamentals of the company and compare it with price to reach a conclusion. The four fundamentals are earning, earning growth, dividend, and book value.
#D1. Price Earning Ratio (P/E)
This is one of the most referred price valuation ratio of all. It is a ratio between market price of stock and its earning per share (EPS). It represent the price multiple of a stocks with respect to its earning per share.
I’ve written a detail article on Price Earning Ratio (P/E). It talks about how we investors can use P/E ratio more effectively. Please read it once. I’m sure it will add value to your knowledge.
In terms of formula, price earning ratio looks like this:
= Current Price / Earning Per Share
As a rule of thumb, P/E multiple above the sectors average hints towards overvaluation. There is also simpler rule. P/E above 15 is considered high.
#D2. Price-Earning To Growth Ratio (PEG)
Utility of P/E ratio in isolation is not as much. But when it is used in conjunction with future earning growth prospects of the company, it becomes an exemplary price valuation tool.
I have written a detail article on the subject of PEG Ratio. I’m sure you will get more insights about price valuation of stocks after reading it. If possible, go throught it please.
In term of formula, PEG ratio looks like this:
= PE Ratio / EPS Growth Rate
As a general rule, when PEG ratio is below 1, the stock is considered as undervalued. Suggested Reading: PEG Ratio
#D3. Price To Book Value Ratio (P/B)
As P/E ratio compares stock’s price with PAT/EPS, P/B ratio compare price with book value. Before one can make a comparison of price to book value it is essential to know what is book value. This knowledge will highlight why a comparison of price with book value makes sense. I’ve written a detail article on book value. I think it will be a great read for you.
In terms of formula, price to book value ratio looks like this:
= Current Price / Book Value Per Share
As a general rule, when P/B ratio is above 1.5, the stock is considered as overvalued. Suggested Reading: A comprehensive guide on book value of a company.
#D4. Dividend Yield
Dividend yield is perhaps the most real price valuation indicator of all. But the problem with this ratio is that, not all good stocks pay dividends to their shareholders. Hence, not every stock can be analyzed using this ratio.
But fortunately most blue chip companies are very reliable dividend paymasters.
We can see dividend yield like this: as fixed deposits yield interest stocks yield dividends. Hence, valuing a stock using dividends is similar to valuing a fixed deposits using interests.
I’ve also written an interesting post on the dividend yield formula. You can read it as well to make more meaning of how dividend yield is derived, and why it makes sense when we compare it with price.
= Dividend Per Share / Current Price
What we have studied here is a list of 21 financial ratios. These are those ratios which I also use in my stock analysis worksheet to estimate stock’s fundamentals strengths and price valuation.
But why we need to handle so many ratios? Because no single metric can define the company’s fundamentals on its own. So many ratio is also symbolic of the number of shades a company has behind its back.
Actually its quite awesome when you do financial ratio analysis of a company. Sometimes it is also overwhelming. But more often than not I love doing such calculation for my companies. So I know how time-consuming this exercise can become at times. Hence I’ve built an excel worksheet for myself which does all these calculations for me in a jiffy.