Before making any investment, it is essential that an investor analyses the basic fundamentals of the issuing company to perceive its performance. Ratios help us understand the whole picture with just a few numbers but since numbers can be a little overwhelming, here’s an easy way of understanding important ratios while considering an investment:
Ratios common throughout different industries:
To Judge – True Size of a company’s Owned Funds
Look at – Adjusted Tangible Net Worth
Adjusted Tangible Net Worth (ATNW) is the value of net worth after adjusting inter-company loans and advances and intangible assets from the total net worth. Loans and advances taken from group companies is deducted while loans and advances given to group companies is added to total net worth. Ideally unprovided losses and provisions should also be adjusted against the company’s net worth. From this figure, intangible assets are deducted to finally arrive at Adjusted Tangible Net Worth. This ratio gives a consolidated view of the company’s net worth and is further used to calculate other ratios like Return on Assets, etc.
To Judge – Funding mix of the company is terms of Debt and Equity
Look at – Capital Gearing Ratio
Gearing denotes the financial risk undertaken by the company reflected by its funding mix. A high level of debt translates to high fixed cost in terms of interest payment. Gearing is calculated by dividing the company’s debt with its equity. Higher the gearing, higher the debt proportion. A high level of gearing can result in deterioration of a company’s bottom line due to high interest cost. The most ideal level of gearing would be between 0.5x to 1x and the most non satisfactory level would be 2x or above.
To Judge – Business Growth
Look at – Revenue and Profit Margins
The first figure that comes to mind when it comes to growth is revenue, a company’s top line growth depicts the growth in its business. Growth in margins depicts increasing efficiencies in the business which also signifies growth.
To Judge – Ability to pay Interest
Look at – Interest Coverage Ratio
This ratio indicates the extent of cover available to pay off interest expenses. Earnings before interest and tax (EBIT) is divided by interest expenses to arrive at interest coverage ratio. Hence higher the interest coverage ratio, higher the company’s ability to pay interest.
To Judge – Solvency
Look at – Solvency Ratio
Solvency ratio indicates a company’s ability to repay its debt. It is calculated by divided PAT (including depreciation) by total debt of the company. The ratio is expressed as a percentage, higher the ratio higher the solvency of the company. Solvency ratios focus on cash flows and includes all obligations hence it is considered to be a reliable ratio for judging the company’s ability to repay debt.
Ratios to be assessed in case of financial services industry:
To Judge – Capital Strength against Risky Assets
Look at – Capital Adequacy Ratio
This ratio measures the bank’s available capital as a percentage of its risk-weighted credit exposures. Risk weighted assets are credit exposures that are weighed based on their risks. To assign weightage several parameters are analyzed and then risk weighted assets are used for measuring Capital Adequacy Ratio. Hence this ratio is also referred as Capital-to-risk assets ratio (CRAR). CAR measures to types of capital – Tier 1 and Tier 2. Tier 1 capital is ordinary capital that can absorb bank losses without the bank having to shut down its operations. Tier 2 is a risker class as this is the capital that can absorb losses after the bank shuts down operations. After combining Tier 1 and Tier 2 capital, this figure is divided by the bank’s total risk weighted assets. As on Sep’21, RBI mandates Indian scheduled commercial banks to maintain a CAR of more than or equal to 9% while Indian public sector banks are emphasized to maintain a CAR of more than or equal to 12%.
To Judge – Resource Profile of banks
Look at – Proportion of Current and Saving Account (CASA) in Total Deposits
Current Account and Saving Account deposits are cheaper than most sources of funding and hence higher the proportion of CASA, lower the cost of borrowing which eventually results in higher margins.
To Judge – Asset Quality
Look at – Gross and Net Non-Performing Assets
Asset quality reflects the banks risk management practices. Strong asset quality is essential for operational efficiencies. Any deterioration in asset quality impacts the bank’s profitability by way of higher cost of borrowing and weakening income profile. Extremely weak asset quality can result in capital erosion which will weaken the bank’s growth. Gross and Net NPAs are denoted as percentage of NPA divided by advances. The only difference is Gross NPA % is derived before adjusting provisions while Net NPA % is derived after adjusting provisions.
To Judge – Liquidity Position
Look at – Asset Liability Mismatch and Liquidity Coverage Ratio (LCR)
Asset Liability Mismatch (ALM) is a ratio that indicates the mismatch between maturities of funds borrowed and funds lent. A negative ALM could be a result of diverting short term funds for long term use. In other words, when short term funds are used for long term lending, the maturity of paying back comes before the maturity of receiving these funds. Banks maintain positive ALM to be able to repay their debt when its due.
Liquidity Coverage Ratio (LCR) under RBI rules is a mandate of holding a specific amount of high-quality liquid assets that are enough to fund the cash outflows for at least 30 days. As per Basel III Framework on Liquidity Standards, banks are required to maintain 100% LCR effective from 01-04-2021.
Ratios to be assessed in case of industries other than financial services:
To Judge – The company’s capital strength against its borrowed funds
Look at – Leverage
Simply put, leverage is calculated by dividing outside funds with owned funds. Outside funds should not include inter-company funds, these should be adjusted with owned funds. For example, if the company has borrowed funds from one of its group companies, instead of considering it as borrowed funds it will be added to owned funds. Owned funds in this case would be the company’s ATNW.
To Judge – The company’s ability to generate profit by using its capital
Look at – Return on Capital Employed (ROCE)
This ratio shows how effectively the company has allocated its capital in order to generate returns. Hence if you are going to invest towards the company’s capital you need to know if that capital is being allocated well to fulfill its ability to generate returns. This ratio is particularly useful in capital intensive industries. It is calculated by dividing Earnings before Interest and Tax (EBIT) by the capital employed. Capital employed includes both, equity as well as debt. Higher the ratio, better the performance.
To Judge – How much return the company is earning considering its total assets
Look at – Return on Assets
This ratio is calculated by dividing net income by total average assets of the company. It shows how much returns the company’s assets are generating and thereby signifies the effectiveness with which they have been allocated to achieve these returns. It is useful for asset heavy companies. Higher the ROA, higher the efficiency of asset utilization.
To Judge – Receivable collection period
Look at – Debtor days
This ratio is used to understand the number of days the company takes to collect cash from its debtors after the sale transaction. Lower debtor days depicts that the company is able to collect cash at a faster pace.
To Judge – Inventory ageing
Look at – Inventory Days
This ratio is used to understand the number of days it takes for the company to convert its inventory in to sales. A high inventory level results in a high number of inventory days and the higher the number of inventory days lesser the number of turnovers in one particular year.
To Judge – Credit period allowed by suppliers
Look at – Creditor days
It shows the number of days the company usually takes to make payment to its creditors for its purchases. Suppliers allowing higher number of credit days to the company implies that the relation between them is strong and built on trust. Higher number of days implies that the company is allowed a higher credit period.
To Judge – to judge how quickly the company can turn its assets in to cash
Look at – Net Working Capital
Debtor Days + Inventory Days – Creditor days = Net Working Capital Cycle
It shows the amount of time a company takes to convert its inventory in to sales and then the time to convert receivables from sales to cash after deducting the time taken to pay its creditors for purchases. The longer the net working capital days, the lesser number of cycles in a year. Which shows that the company’s cash is tied in its assets for a longer time without earning returns.
To Judge – Cash generation from the business
Look At – Cash flow from operating activities
It shows how much cash the company is able to generate solely from its operational activities. Companies in growth an expansion mode usually have a negative cash flow from operations. Other than that, any company having a negative cash flow from operations is a red flag. It has a direct impact on the company’s liquidity. Positive cash flow demonstrates the amount of free cash the company has to undertake other activities such as buy back and expansion.
To Judge – Liquidity
Look at – Current Ratio
Current ratio is calculated by dividing current assets by current liabilities. It shows whether the company has enough assets to cover its liabilities in the short term. Current ratio is considered to be healthy when its either to equal to or above 1.