Financial Ratio Analysis : List of Financial Ratios
Profitability and Efficiency Ratios
Profitability ratios measures a company’s ability to generate earnings & cash flows on its revenues, assets and equities whereas efficiency ratios measures how effectively a firm uses its assets to generate revenues and how well it manages its liabilities.
Gross margin measures the percentage of gross profit left after cost of goods sold from revenues. Generally, gross margin will be lower for companies with capital intensity and high fixed cost; lower gross margin are associated with companies that do their own manufacturing. Higher gross margins are associated with lower capital intensity, outsourced production and a higher portion of variable costs. Business services are examples of industries with higher gross margins.
Operating margin ideally indicates a company’s profitability purely from the course of its business and to the exclusion of inputs related to prior financial decisions i.e. interest paid on debt or earned on cash or non-operating event i.e. taxes.
Pretax margin is effectively operating margin adjusted for non-operating financial structure strategy and decisions. The primary adjustment levers are interest income and interest cost, but they are not the only factors. Line items between operating income and pretax income can include effects of other financing decisions, including debt prepayments and net realized investment gains, as well as foreign exchange effects and others.
Net margin represent net income as a percentage of revenue. Line items that contribute to the difference between pretax income and net income of course include taxes, but also may include equity income, minority interest, and loss from discontinued items, accounting changes and others.
The value of Return on Capital Employed (RoCE) is that it can be used to provide a consistent measure of cash-based return of a company over an extended period. Single period cash flows can be manipulated by management, but cash flow over an economic cycle is more difficult to manipulate.
Return on Asset (RoA) has the most value when used to compare return performance across carefully constructed universes of like entities. Financial firms and insurers in particular tend to have low RoA; Technology firms tend to have high RoA due to being low capital intensive.
Return on equity (RoE) measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
The Du Pont identity breaks down Return on Equity into three distinct elements. This analysis enables the analyst to understand the source of return by comparison with companies in similar industries.
High margin industries. Industry, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE.
High turnover industries. Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance.
High leverage industries. Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. Other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables third parties that rely primarily on their financial statements to compare leverage among similar companies.
Financial Risk Ratios
Working capital measures the difference between a company’s current assets and current liabilities. Historically high level of working capital in excess of current assets over current liabilities have been regarded positively because they show a company as being highly liquid to meet immediate cash needs. In a downturn, high working capital can serve as a kind of a “bank” for the well managed enterprise; key current asset accounts can be drawn down, which is contributory to cash flow and may help keep cash flow positive amid negative profit performance. Poor working capital management in a down cycle, on the other hand is seen by investors as an inducement of management.
Current ratios shows the difference between current accounts and current liabilities, expressed as a ratio. For most sectors, investors want to see positive current ratio > 1.5. When economy tanks, investors want to see current ratio decline as companies improve collections and cut inventories to free up and preserve cash.
Quick ratio is considered by some investors a better gauge of liquidity and cash availability than current ratio. It is defined as the sum of cash & accounts receivable divided by current liabilities. Creditors like to see a quick ratio exceeding 1; again, there can be some sector-based and industry based variability in average ratios.
Debt to Equity provides a quick snapshot on how a company chooses to fund its strategy. Interest coverage ratio measures a company’s ability to meet the accounting interest obligations on its debt. Although EBIT, is a book accounting concept, the exclusion of book taxes and interest remove the two inputs with the most variance from cash-based taxes and interest. Therefore, it is best measure to use.
Credit rating indicators provided by rating agencies to investors signal creditworthiness of a debt issuer or a specific debt issue. Credit rating changes are upgrades & downgrades of a firm’s credit rating.
Market Risk Ratios
Liquidity is defined as the ability of an asset to be converted into cash quickly without any price discounts. Turnover is the average daily volume divided by shares outstanding in the past T days.
Illiquidity is the average ratio of daily absolute return to the rupee trading volume on the same day. The ratio gives the average percentage price change for each rupee of trading volume, which is a rough measure of price impact. A less liquid stock tends to have higher illiquidity value.
Relative volume is the ratio of a stock’s short-term average daily volume to its long-term average daily volume.
Beta is a measure of relationship of a stock with respect to a benchmark indices.
Standard deviation is a measure of volatility from the past performance of a stock.
Valuation ratios compares the value of an asset with that of another. The general idea is that assets with similar earnings sales, cash flows or book values should have similar prices. In another words, firms with similar characteristics should have similar price to earnings, price to sales, price to cash flow and price to book ratios.
In many value measures, the numerator is either price, market cap or enterprise value.
Enterprise Value (EV) based measure give the deleveraged perspective on sales and earnings, which are valuable when we compare companies with significant differences in their debt levels.
The EV principle is based on the fact that an acquirer will have to take on all the liabilities of the company including debt and preference shares. Cash and cash equivalents are subtracted as it reduces the acquisition cost.
Full market cap is the total number of shares outstanding multiplied by the share price while free float market cap is the number of shares outstanding excluding management holdings multiplied by the share price.
High PE and low PE are defined in absolute terms. A stock trading at a PE of 25 times is trading at a higher PE than a stock trading at a PE of 12 times. High PE stocks imply growth or future growth prospects while low PE stocks imply slow and steady growth. High and low PE stocks can also imply issues of corporate governance, issues of debt, issues of profitability, issues of return on capital or return on equity, issues of risk aversion and other such issues. High PE does not mean overvaluation or low PE does not mean undervaluation.
PE while reflecting growth potential of a company also reflects a company’s fundamentals in terms of debt, corporate governance, return ratios and cash levels. PE could also reflect market sentiments or it could reflect expected corporate actions.
PE ratios can be looked at in two ways. Spotting the right way of looking at the PE ratio will lead to an optimum investment decision. The two ways of looking at PE ratios are:
- Comparing individual stock PE to the index PE, sector PE and peer group PE
- Analyzing future prospects and judging whether the stock is expensive or inexpensive in terms of PE
Forward EPS is a better indicator as it gives the forecast earnings of the company. Usually companies guide for forward earnings or it can be taken from consensus analysts’ estimates for a one year or above period. If the company does not give guidance or if there is no consensus earnings estimates, forward earnings can be calculated based on growth and profitability rates indicated in quarterly results or from guidance of competitors.
PEG ratio assumes a certain EPS growth forecast. To some extent the PE ratio should also reflect EPS growth forecast as PE ratios usually discount future earnings and not historical earnings.
P/BV ratio is relevant for some sectors and no so relevant for other sectors. Banks are compared on a P/BV basis as it indicates the efficiency of equity to leverage the balance sheet. Sectors where replacement or market value concept is prevalent such as cement, power and real estate have more relevance for book value per share than sectors where fixed assets are not heavy.
Companies where managements are improving the quality of earnings should see an improvement in the P/CF valuations.
EBITDA or earnings before interest, tax, depreciation and amortization is the amount of cash a company generates from sales. The EV/EBITDA ratio measures a firms value in relation to its cash generated from operations and the lower the ratio the better in valuation terms.
EV/EBITDA ratio cannot be applied across sectors as different sectors have different earnings metrics. For example EV/EBITDA is not a right tool for the financial sector as interest component is a large part of the sectors expenditure. EV/EBITDA is more useful for companies in FMCG/IT/Pharmaceuticals sectors where sales volumes and gross margins are important.
Cross-sectional analysis is done by comparing ratios of similar companies within the industry or industry norms.
Britannia industries is single listed biscuit maker and similar company such as Parle, Priya gold and ITC biscuit segment isn’t listed. But Britannia industries is categorized in the food processing industry and we will compare the ratio with them.
Relatively Britannia industries has the highest return ratios, asset turnover (AT) is lot better when compared to its peers. However margins are tad lower than the average, probably due to higher expenses towards advertisements and impact of demonetization in the year.
When we make choice for investing, our investment decision is based on future performance of the company so we need to make a comparative valuation with respect to future performance of Britannia and its peers. Below in the table are future estimates of the companies’ earnings for full year FY17-FY18 & FY18-FY19.
The forward EPS is derived by projecting the performance of these companies into future. It is done by the way of financial modelling of financial statements and forecasted based on future growth prospects of these companies. The data is taken from a brokerage report covering these stocks.
Britannia industries is expected to grow at a higher rate in FY18 & FY19 as compared to its peers but the current price is already trading at a premium in terms of FY18E earnings but at a discount of nearly 12% to its FY19 estimate. Compared to peers Glaxo consumer is available at a better price for investing.
Target price is arrive by multiplying the 5 year average PE with forward year EPS estimates.
Companies with similar products and attributes such as cement, target price is calculated by multiplying the forward year average PE of all stocks within the industry with that forward year EPS estimate.