Financial analysis and planning : The basis for financial analysis, planning, and decision-making is financial statements which mainly consist of a Balance Sheet and a Profit and Loss Account. The profit & loss account shows the operating activities of the concern over a period of time and the balance sheet depicts the balance value of the acquired assets and of liabilities or in other words, the financial position of an organization at a particular point in time.
However, the above statements do not disclose all of the necessary and relevant information. For the purpose of obtaining the material and relevant information necessary for ascertaining the financial strengths and weaknesses of an enterprise, it is necessary to analyze the data depicted in the financial statement:
The financial manager has certain analytical tools which help in financial analysis and planning. One of the main tools is Ratio Analysis. Let us discuss the Ratio
Let us first understand the definition of ratio and the meaning of ratio analysis,
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Definition of Ratio
Financial analysis and planning: A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or more things.” Here, ratio means financial ratio or accounting ratio which is a mathematical expression of the relationship between two accounting figures.
Ratio Analysis
The term financial ratio can be explained by defining how it is calculated and what the objective of this calculation is?
a. Calculation Basis (Basis of Calculation):
- A relationship expressed in mathematical terms
- Between two individual figures or group of figures
- Connected with each other in some logical manner
- Selected from financial statements of the concern
b. Objective for financial ratios is that all stakeholders (owners, investors,lenders, employees etc.) can draw conclusions about the:
Performance (past, present, and future) Strengths & weaknesses of a firm Can take decisions in relation to the firm
Ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed relative to some other figure, it may definitely provide some significant information.
Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It is comparing the number against
previous years (intra-firm comparison) and, other companies (inter-firm comparison), the industry, or even the economy in general for the purpose of financial analysis.
Sources of Financial Data for Analysis
The sources of information for financial statement analysis are:
1. Annual Reports
2. Interim financial statements
3. Notes to Accounts
4. Statement of cash flows
5. Business periodicals.
6. Credit and investment advisory services
Liquidity Ratios
Financial analysis and planning: The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. Liquidity or short-term solvency means the ability of the business to pay its short-term liabilities. The inability to pay off short-term liabilities affects its credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy.
Eventually, such commercial bankruptcy may lead to its sickness and dissolution. Short-term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake. Both lack of sufficient liquidity and excess liquidity is bad for the organization.
Various Liquidity Ratios are:
(a) Current Ratio
(b) Quick Ratio or Acid test Ratio
(c) Cash Ratio or Absolute Liquidity Ratio
(d) Basic Defense Interval or Interval Measure Ratios
(e) Net Working Capital
(a) Current Ratio: The Current Ratio is one of the best-known measures of short-term solvency. It is the most common measure of short-term liquidity.
The main question this ratio addresses is: “Does your business have enough
current assets to meet the payment schedule of its current debts with a margin
of safety for possible losses in current assets?” In other words, the current ratio
measures whether a firm has enough resources to meet its current obligations.
Current Ratio :
Current Assets / Current Liabilities
Where,
Current Asset = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other current assets.
Current Liabilities= Creditors for goods and services Short-term Loans Bank Overdraft Cash Credit Outstanding Expenses Provision for Taxation + Proposed Dividend Unclaimed Dividend Any other current liabilities.
Interpretation
A generally acceptable current ratio is 2:1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities.
(b) Quick Ratio: The Quick Ratio is sometimes called the “acid-test” ratio and
is one of the best measures of liquidity.
Quick Ratio or Acid Test Ratio= Quick Assets / Current Liabilities
Where,
Quick Assets: Current Assets-Inventories- Prepaid expenses
Current Liabilities= As mentioned under Current Ratio.
The Quick Ratio is a much more conservative measure of short-term liquidity than the Current Ratio.
It helps answer the question: “If all sales revenues should disappear, could my business meet its current obligations with the readily convertible quick funds on hand?”
Quick Assets consist of only cash and near cash assets. Inventories are deducted
from current assets on the belief that these are not ‘near cash assets and also
because in times of financial difficulty, inventory may be saleable only at
liquidation value. But in a seller’s market, inventories are also near cash assets.
Interpretation
An acid-test of 1:1 is considered satisfactory unless the majority of “quick assets” are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.
(c) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business. This ratio considers only the absolute liquidity available with the firm. This ratio is calculated as:
Cash Ratio = Cash and Bank balances + Marketable Securities / Current Liabilities
Or,
Cash and Bank balances + Current Investments / Current Liabilities
Interpretation
The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities/ current investments.
(d) Basic Defense Interval/ Interval Measure:
Basic Defense Interval = Cash and Bank balances + Net Receivables + Marketable Securities / Opearing Expenses+ No.ofdays (say 350)
Or
Current Assets – Prepaid expenses – Inventories / Daily Operating Expenses
Cost of Goods Sold+Selling Administartion and other
Daily Operating Expenses = General expenses-Depreciation and other non cash expenditure / No. of days in a year
Interpretation
If for some reason all the company’s revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days for which the company can cover its cash expenses without the aid of additional financing.
(e) Net Working Capital: Net working capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. However, in
certain business models it may be negative. It is calculated as shown below:
Net Working Capital = Current Assets – Current Liabilities (Excluding short-term bank borrowing)
Interpretation
Bankers look at Net Working Capital over time to determine a company’s ability to weather financial crises. Loans are often tied to minimum working capital requirements.
Long-term Solvency Ratios/Leverage Ratios
The leverage ratios may be defined as those financial ratios which measure the long-term stability and capital structure of the firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long-term funds with regard to:
(i) Periodic payment of interest during the period of the loan and
(ii) Repayment of principal amount on maturity.
Leverage ratios are of two types:
1. Capital Structure Ratios
(a) Equity Ratio
(b) Debt Ratio
(c) Debt to Equity Ratio
(d) Debt to Total Assets Ratio
(e) Capital Gearing Ratio
(f) Proprietary Ratio
2. Coverage Ratios
(a) Debt-Service Coverage Ratio (DSCR)
(b) Interest Coverage Ratio
(c) Preference Dividend Coverage Ratio
(d) Fixed Charges Coverage Ratio
Capital Structure Ratios
These ratios provide an insight into the financing techniques used by a business and focus, as a consequence, on the long-term solvency position.
From the balance sheet, one can get only the absolute fund employed and its sources but only capital structure ratios show the relative weight of different sources.
Various capital structure ratios are:
(a) Equity Ratio: Equity Ratio = Shareholder’s Equity / Net Assets
The shareholder’s equity is Equity share capital and Reserves & Surplus (excluding fictitious assets etc). Net Assets or Capital employed includes Net Fixed Assets and Net Current Assets (Current Assets – Current Liabilities).
This ratio indicates proportion of owner’s fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owner’s fund, lower is the degree of risk for potential lenders.
(b) Debt Ratio:
Debt Ratio = Total Debt / Net Assets
Total debt or total outside liabilities includes short and long term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipment, bank borrowings, public deposits and any other interest bearing loan.
Interpretation
This ratio is used to analyse the long-term solvency of a firm. A ratio greater than 1 would mean greater portion of company assets are funded by debt and could be a risky scenario.
(c) Debt to Equity Ratio:
Debt to Equity Ratio = Total Outside Liabilities / Shareholders’ Equity = Total Debt / Shareholder’s Equity
Long-term Debt / Shareholders’ equity
*Not merely long-term debt i.e. both current & non-current liabilities. Sometimes only interest-bearing, long-term debt is used instead of total liabilities (exclusive of current liabilities)
Interpretation
A high debt to equity ratio here means less protection for creditors, a low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner’s funds can help absorb possible losses of income and capital). This ratio indicates the proportion of debt fund in relation to equity. This ratio is very often used for making capital structure decisions such as issue of shares and/ or debentures. Lenders are also very keen to know this ratio since it shows relative weights of
debt and equity. Debt equity ratio is the indicator of firm’s financial leverage.
(d) Debt to Total Assets Ratio: This ratio measures the proportion of total assets financed with debt and, therefore, the extent of financial leverage.
Debt to Total Assets Ratio = Total Outside Liabilities / Total Assets
Or,
Total Debt / Total Assets
Higher the ratio, indicates that assets are less backed up by equity and hence higher financial leverage.
(e) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to show the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders i.e. equity funds or net worth. Again, higher ratio may indicate more risk.
(e) Capital Gearing ratio
Preference Share Capital +Debentures+ Other Borrowed funds
Equity Share Capital+ Reserves & Surplus-Losses
(f) Proprietary Ratio:
Proprietary Ratio = Proprietary Fund / Total Assets
Proprietary fund includes Equity Share Capital, Preference Share Capital and
Reserve & Surplus. Total assets exclude fictitious assets and losses.
Interpretation
It indicates the proportion of total assets financed by shareholders. Higher the ratio, less risky scenario it shall be.
Coverage Ratios
The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios establish the relationship between fixed claims and what is normally available out of which these claims are to be paid. The fixed claims consist of:
(i) Interest on loans
(ii) Preference dividend
(iii) Amortisation of principal or repayment of the instalment of loans or redemption of preference capital on maturity.
The following are important coverage ratios:
(a) Debt Service Coverage Ratio (DSCR): Lenders are interested in debt service coverage to judge the firm’s ability to pay off current interest and instalments.
Debt Service Coverage Ratio = Earnings available for debt services Interest + Installments
Earnings available for debt service*
= Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other amortizations + Interest + other adjustments like loss on sale of Fixed Asset etc.
*Fund from operations (or cash from operations) before interest and taxes also can be considered as per the requirement.
Interpretation
Normally DSCR of 1.5 to 2 is satisfactory. You may note that sometimes in both
numerator and denominator lease rentals may also be added.
(b) Interest Coverage Ratio: This ratio also known as “times interest earned ratio indicates the firm’s ability to meet interest (and other fixed charges) obligations. This ratio is computed as:
Interest Coverage Ratio = Earnings before interest and taxes (EBIT) / Interest
Interpretation
Earnings before interest and taxes are used in the numerator of this ratio because the ability to pay interest is not affected by tax burden as interest on debt funds is deductible expense. It measures how many times a company can cover its current interest payment with its available earnings? In other words, it reflects the margin of safety a company has for paying interest on its debt during a given period.
A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations.
(c) Preference Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return,
This ratio is computed as: Preference Dividend Coverage Ratio = Net Profit/Earning after taxes (EAT) / Preference dividend
Interpretation
This ratio indicates margin of safety available to the preference shareholders.
higher ratio is desirable from preference shareholders point of view. Similarly, Equity Dividend coverage ratio can also be calculated as:
Equity Dividend Coverage Ratio = Earning after taxes (EAT) – Preference dividend
Equity dividend
(d) Fixed Charges Coverage Ratio: This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. This ratio of more than 1 is considered as safe.
Fixed Charges Coverage Ratio= EBIT Depreciation / Interest + Repayment of Loan
Notes for calculating Ratios:
1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and
taxes). EAT (Earnings after taxes) = PAT (Profit after taxes), EBT (Earnings before taxes) = PBT (Profit before taxes)
2. Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given. Numerator should be taken in correspondence with the denominator and vice-versa.
Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios
These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. For this reason, they are often called as ‘Asset management ratios’. These ratios usually indicate the frequency of sales with respect to its assets. These assets may be capital assets or working capital or average inventory.
Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios:
(a) Total Assets Turnover Ratio
(b) Fixed Assets Turnover Ratio
(c) Capital Turnover Ratio/ Net Assets Turnover Ratio
(d) Current Assets Turnover Ratio
(e) Working Capital Turnover Ratio
(i) Inventory/ Stock Turnover Ratio
(ii) Receivables (Debtors) Turnover Ratio (iii) Payables (Creditors) Turnover Ratio
These ratios are usually calculated with reference to sales/cost of goods sold and are expressed in terms of rate or times.
(a) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets. Higher the ratio, better it is. This ratio is computed as:
Total Asset Turnover Ratio = Sales/Cost of Goods Sold / Total Assets
Interpretation
A high total assets turnover ratio indicates the efficient utilisation of total assets in generation of sales. Similarly, a low asset turnover ratio indicates total assets
are not efficiently used to generate sales.
(b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm
uses its fixed assets.
Fixed Assets Turnover Ratio = Sales/Cost of Goods Sold / Fixed Assets
Interpretation
A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating sales. A firm whose plant and machinery are old may show a higher fixed assets turnover ratio than the firm which has purchased them recently.
(c) Capital Turnover Ratio/ Net Asset Turnover Ratio:
Capital Turnover Ratio = Sales/Cost of Goods Sold / Net Assets
Interpretation
Since Net Assets equals to capital employed it is also known as Capital Turnover Ratio. This ratio indicates the firm’s ability of generating sales/ Cost of Goods Sold per rupee of long-term investment. The higher the ratio, the more efficient is the utilisation of owner’s and long-term creditors’ funds.
(d) Current Assets Turnover Ratio: It measures the efficiency of using the current assets by the firm.
Current Assets Turnover Ratio = Sales/Cost of Goods Sold / Current Assets
Interpretation
The higher the ratio, the more efficient is the utilisation of current assets in generating sales.
(e) Working Capital Turnover Ratio: It measures how effective a company is at generating sales for every rupee of working capital put to use.
Working Capital Turnover Ratio Sales/Cost of Goods Working Capital Sold
Interpretation
Higher the ratio, the more efficient is the utilisation of working capital in generating sales. However, a very high working capital turnover ratio indicates that the company needs to raise additional working capital for future needs. Working Capital Turnover is further segregated into Inventory Turnover, Debtors
Turnover, and Creditors Turnover, Note: Average of Total Assets/ Fixed Assets/Current Assets/ Net Assets/Working
Capita also can be taken in the denominator for the above ratios.
(i) Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover
ratio establishes the relationship between the cost of goods sold during the year and average inventory held during the year. It measures the efficiency with which a firm utilizes or manages its inventory. It is calculated as follows:
Inventory Turnover Ratio Costof Goods Sold/Sales Average Inventory Average Inventory Opening Stock+ Closing Stock
2 In the case of inventory of raw material, the inventory turnover ratio is calculated using the following formula:
Raw Material Inventory Turnover Ratio = Raw Material Consumed Average Raw Material Stock
Interpretation
This ratio indicates that how fast inventory is used or sold. A high ratio is good from the view point of liquidity and vice versa. A low ratio would indicate that inventory is not used/sold/lost and stays in a shelf or in the warehouse for a long time.
(ii) Receivables (Debtors) Turnover Ratio: In case firm sells goods on credit, the realization of sales revenue is delayed and the receivables are created. The cash is realised from these receivables later on,
The speed with which these receivables are collected affects the liquidity position of the firm. The debtor’s turnover ratio throws light on the collection and credit policies of the firm. It measures the efficiency with which management is managing its accounts receivables. It is calculated as follows:
Receivables (Debtors) Turnover Ratio= Credit Sales / Average Accounts Receivable
A low debtors turnover ratio reflects liberal credit terms granted to customers,
while a high ratio shows that collections are made rapidly.
Receivables (Debtors) Velocity/Average Collection Period: Debtor’s turnover ratio indicates the average collection period. However, the average collection period can be directly calculated as follows:
Average Accounts Receivables / Average Daily Credit Sales
Or
12 months/52 weeks/360 days / Receivable Turnover Ratio
Average Daily Credit Sales = Credit Sales / No.of daysinyear (say360)
Interpretation
The average collection period measures the average number of days it takes to collect an account receivable. This ratio is also referred to as the number of days of receivable and the number of day’s sales in receivables. In determining the credit policy, debtor’s turnover and average collection period provide a unique guidance.
(iii) Payables Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is calculated. It measures how fast a company makes payment to its creditors. It shows the velocity of payables payment by the firm. It is calculated as follows:
Payables Turnover Ratio = Annual Net Credit Purchases Average Accounts Payables
A low creditor’s turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are settled rapidly.
Payable Velocity/ Average payment period can be calculated using:
Average Accounts Payable Or 12 months/52 weeks/360 days Average Daily Credit Purchases Payables Turnover Ratio
Interpretation
The firm can compare what credit period it receives from the suppliers and what it offers to the customers. Also, it can compare the average credit period offered to the customers in the industry to which it belongs.
The above three ratios le. Inventory Turnover Ratio/ Receivables Turnover Ratio/Payables Turnover Ratio are also relevant to examine liquidity of an organization.
Notes for calculating Ratios:
1. Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and Cost of Sales (COS) in its absence, COGS will be equal to sales.
2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratioseliminating profit part.
3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital also can be taken in denominator while calculating the above ratios. In fact, when average figures of total assets, net assets, capital employed, shareholders’ fund etc. are available it may be preferred to calculate ratios by using this information.
4. Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given.
Profitability Ratios
The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to maximize the firm’s value.
The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales or owner’s interest etc. Therefore, the profitability ratios are broadly classified in four categories:
(i) Profitability Ratios related to Sales
(ii) Profitability Ratios related to overall Return on Investment
(iii) Profitability Ratios required for Analysis from Owner’s Point of View
(iv) Profitability Ratios related to Market/Valuation/ Investors
Profitability Ratios are as follows:
1. Profitability Ratios based on Sales
(a) Gross Profit Ratio
(b) Net Profit Ratio
(c) Operating Profit Ratio
(d) Expenses Ratio
Profitability Ratios related to Overall Return on Assets/ Investments
(a) Return on Investments (ROI)
(i) Return on Assets (ROA)
(ii) Return of Capital Employed (ROCE) (iii) Return on Equity (ROE)
3. Profitability Ratios required for Analysis from Owner’s Point of View
(a) Earnings per Share (EPS)
(b) Dividend per Share (DPS)
(c) Dividend Pay-out Ratio (DP)
4. Profitability Ratios related to Market/ Valuation/ Investors
(a) Price Earnings (P/E) Ratio
(b) Dividend and Earning Yield
(c) Market Value/ Book Value per Share (MV/BV)
(d) Q Ratio
Profitability Ratios based on Sales
(a) Gross Profit (G.P) Ratio/ Gross Profit Margin: It measures the percentage
of each sale in rupees remaining after payment for the goods sold.
Gross Profit Ratio = Gross Profit / Sales x100
Interpretation
Gross profit margin depends on the relationship between sales price, volume and costs. A high Gross Profit Margin is a favourable sign of good management. (b) Net Profit Ratio/ Net Profit Margin: It measures the relationship between net profit and sales of the business. Depending on the concept of net profit, it can be calculated as:
Net Profit Sales= Net Profit Ratio / Sales x100
Or Earnings after taxes (EAT)/ Sales x100
(i) Pre-tax Profit Ratio = Earnings before taxes (EBT)x100
Interpretation
Net Profit ratio finds the proportion of revenue that finds its way into profits after meeting all expenses. A high net profit ratio indicates positive returns from the business.
(c) Operating Profit Ratio:
Operating profit ratio is also calculated to evaluate operating performance of business.
Operating Profit Ratio = Operating Profit Sales x100
Earnings before interest and taxes (EBIT)/ Sales x100
Operating Profit = Sales – Cost of Goods Sold (COGS) – Operating Expenses
Interpretation
Operating profit ratio measures the percentage of each sale in rupees that remains after the payment of all costs and expenses except for interest and taxes. This ratio is followed closely by analysts because it focuses on operating results. Operating profit is often referred to as earnings before interest and taxes or EBIT.
(d) Expenses Ratio: Based on different concepts of expenses it can b expresses in different variants as below:
(i) (Cost of Goods Sold(COGS) Ratio = COGS/ Sales X100 Sales
(ii) Operating Expenses Ratio Administrative exp. Selling & Distribution OH Sales
(iii) Operating Ratio= COGS+Operating expenses / Sales × 100
(iv) Financial Expenses Ratio= Financialexpenses* / Sales x100
*It excludes taxes, loss due to theft, goods destroyed by fire etc.
Administration Expenses Ratio and Selling & Distribution Expenses Ratio can also be calculated in similar ways.
(a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. It compares earnings/ returns/ profit with the investment in the company. The ROI is calculated as follows:
Return on Investment= Return/Profit/Earnings / Investment x100
Or,
Return/Profit/Earnings / Sales × Sales/
Investment
Or.
=Profitability Ratio x Investment Turnover Ratio
Since, Profitability Ratio= Return/Profit/Earnings / Sales
Investment Turnover Ratio= Sales/ Investments
and
ROI can be improved either by improving Profitability Ratio or Investment Turnover Ratio or by both.
The concept of investment varies and accordingly there are three categories of ROI i.e.
(i) Return on Assets (ROA),
(ii) Return on Capital Employed (ROCE) and
(iii) Return on Equity (ROE).
We should keep in mind that investment may be Total Assets or Net Assets. Further, funds employed in net assets are also known as capital employed which is nothing but Net worth plus Debt, where Net worth is equity shareholders’ fund. Similarly, the concept of returns/ earnings/ profits may vary as per the requirement and availability of information.
Interpretation
ROCE should always be higher than the rate at which the company borrows.
Intangible assets (assets which have no physical existence like goodwill, patents and trade-marks) should be included in the capital employed. But no fictitious asset (such as deferred expenses) should be included within capital employed. If information is available, then average capital employed shall be taken.
(iii) Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested in the firm. This ratio reveals how profitably of the owners’ funds have been utilised by the firm. It also measures the percentage return generated to equity shareholders. This ratio is computed as:
ROE= Net Profit after taxes – Preference dividend (if any) / Net Worth/Equity Shareholders Funds x100
Interpretation
Return on equity is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdraw cash and reinvest it elsewhere.
Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business. If return on total shareholders (i.e. equity and preference shareholder) is calculated, then Net Profit after taxes (before preference dividend) shall be divided by total shareholders’ fund including preference share capital.
Return on Equity using the Du Pont Model:
A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and serves as the basis of components that make up return on equity.
There are various components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors. The components are as follows:
(i) Profitability/Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue. Net profit margin varies across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales.
Profitability/ Net Profit margin= Profit/ Net Income / Sales/Revenue
Net profit margin is a safety cushion; the lower the margin, the less room for an error. A business with 1% margin has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.
(ii) Investment Turnover/ Asset Turnover/ Capital Turnover. The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:
Investment Turnover/ Asset Turnover/Capital Turnover:- Sales/Revenue / Investment/ Assets/ Capital
The asset turnover ratio tends to be inversely related to the net profit margin i.e. higher the net profit margin, lower the asset turnover and vice versa. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.
(iii) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Investment/Assets/Capital / Shareholders’ Equity
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = (Profitability/ Net profit margin) x (Investment Turnover/ Asset Turnover/Capital Turnover) x Equity Multiplier
Profitability Ratios Required for Analysis from Owner’s Point of View
(a) Earnings per share (EPS): The profitability of a firm from the point of view of ordinary shareholders can be measured in terms of earnings per share basis. It is calculated as follows:
Earnings per share (EPS) = Net profit available to equity shareholders / Number of equity shares outstanding
(b) Dividend per Share (DPS): Earnings per share as stated above reflects the profitability of a firm per share; it does not reflect how much profit is paid as dividend and how much is retained by the business. Dividend per share ratio indicates the amount of profit distributed to equity shareholders per share. It is calculated as:
Dividend per Share (DPS) = Total Dividend paid to equity shareholders / Number of equity shares outstanding
(c) Dividend Pay-out Ratio (DP): This ratio measures the dividend paid in relation to net earnings. It is determined to see to how much extent earnings per share have been retained by the management for the business. It is computed as:
Dividend per equity share(DPS) / Dividend pay-out Ratio = Earning per Share (EPS)
Profitability Ratios related to market/valuation/ Investors
These ratios consider the market value of the company’s shares in calculation. Frequently, share prices data are punched with the accounting data to generate new set of information.
These are (a) Price- Earnings Ratio, (b) Dividend Yield, (c) Market Value/ Book Value per share, (d) Q Ratio.
(a) Price- Earnings Ratio (P/E Ratio): The price earnings ratio indicates the expectation of equity investors about the earnings of the firm. It relates earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders orientation, corporate image and degree of liquidity. It is calculated as
Price-Earnings per Share (P/E Ratio) = Market Price per Share (MPS) / Earning per Share (EPS)
Interpretation
It indicates the payback period to the investors or prospective investors. A higher P/E ratio could either mean that a company’s stock is overvalued or the investors are expecting high growth rates in future. (b) Dividend and Earning Yield:
Dividend Yield = Dividend +Change in share price / Initial share price x100
Or,
Dividend per Share (DPS) Market Priceper Share (MPS) x100
Earnings Yield or EP Ratio = Earningsper Share (EPS) / Market Price per Share (MPS) x100
Interpretation
This ratio indicates return on investment, this may be on average investment or closing investment. Dividend (%) indicates return on paid up value of shares. But yield (%) is the indicator of true return in which share capital is taken at its market value.
(c) Market Value/Book Value per Share (MV/BV): It provides evaluation of how investors view the company’s past and future performance,
Market Value/Book Value per Share (MV/BV) = Average share price / Net worth-No. of equity shares
Or,
Closing share price / Networth-No.of equity shares
Interpretation
This ratio indicates market response of the shareholders’ investment. Undoubtedly, higher the ratio, better is the shareholders’ position in terms of return and capital gains.
(d) Q Ratio: This ratio is proposed by James Tobin, a ratio is defined as
Q Ratio = Market Value of equity and liabilities / Estimated replacement cost of assets
Or,
Market Value of a Company / Assets Replacement Cost
Thus, this ratio represents the relationship between market valuation and intrinsic value.
Equilibrium is when Q Ratio = 1 because when it is less than 1, it could mean that the stock is undervalued and when it is more than 1, it could mean that stock is overvalued.
Notes for calculating Ratios:
1. EBIT (Earnings before interest and taxes) = PBIT (Profit before interest and taxes). EAT (Earnings after taxes) = PAT (Profit after taxes), EBT (Eamings before taxes) = PBT (Profit before taxes)
2. In absence of preference dividend PAT can be taken as earnings available to equity shareholders.
3. If information is available then average capital employed shall be taken while
calculating ROCE
4.Ratios shall be calculated based on requirement and availability of information and may deviate from original formulae. If required, assumptions should be given.
5. Numerator should be taken in correspondence with the denominator and vice-versa.