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Financial statements: Key ratios

Sep 29, 2009

In the previous article of this series, we concluded our discussion about the components that make up a balance sheet. In this article of this series, we shall go though some of the key financial ratios associated with the profit and loss account and the balance sheet.Some of the key financial ratios are:

  • Return on equity (ROE)
  • Return on capital employed (ROCE)
  • Return on invested capital (ROIC)
  • Return on total assets (ROA)
  • Asset Turnover
  • Debt to equity ratio (D/E)
  • Interest coverage ratio

Return on equity (ROE) - ROE is probably the most important ratio in the investing world. It helps in measuring the efficiency with which a company utilises the equity capital. ROE reflects the efficiency with which the management has utilized the shareholders funds. It is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. The result of this calculation should be multiplied into 100.

Return on equity = profit after tax / shareholders funds * 100

One could also take the average equity capital i.e. the average equity of a particular financial year and its preceding financial year. The ratio is also known as the return on net worth (RONW).

It is important to note that this ratio should be compared within companies of a particular industry or intra-industry rather than inter-industry. This exercise helps in knowing which companies have better operating efficiencies and consequently, which managements have been utilising their shareholders' funds more efficiently. An inter-industry comparison does not really make sense as characteristics of different industries vary.

Return on capital employed (ROCE) - Capital employed in simple terms is the value of all assets employed in a business. It can be calculated in two ways -from the 'Application of funds' side and the 'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan funds.

ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed. As such,

ROCE = EBIT / Capital employed * 100

This ratio helps in assessing the returns that a company realises from the capital employed by it. In other words, it represents the efficiency with which capital is being utilized to generate revenue.

Return on invested capital (ROIC) - ROIC shows the returns that a company earns on the capital that is actually invested in the business. It is an important tool which helps in determining how well a company's management is able to allocate capital into its operations for future growth. It is calculated as:

ROIC = (EBIT)*(1 - effective tax rate) / (Capital employed - cash in hand) * 100

As we can see form the above ratio, after reducing the tax from the earnings before interest and tax figure (EBIT), we divide the result by the capital employed (net of the idle cash on hand). The reason we take the EBIT figure is because it includes the PAT and depreciation (which is a non-cash expense). Surplus cash is subtracted from the total capital employed is because it is not actually employed in the business.

Return on total assets (ROA) - ROA is another ratio which helps in indicating the management efficiency. This ratio gives an idea as to how efficiently a company's management is using its assets to earn the profits it is generation. It is calculated by dividing the profit after tax by the total assets as at the end of that year/period. As such,

ROA = Profit after tax / total assets * 100

It measures how profitably the assets of the company have been utilised. Companies with high asset base in capital-intensive industry such as fertilisers and steel tend to have a lower ROA than companies selling branded products such as toothpaste and soaps, which may have a lower asset base. As such, it is important for one to compare the ROAs of companies involved in similar businesses/ industries.

Asset turnover - The asset turnover ratio indicates how well the company is sweating its assets. In other words, it shows how much many rupees a company generates with every rupee invested in assets. This ratio is a measure of how efficiently the company has been in generating sales from the assets at its disposal. It is calculated by dividing the sales by the total assets.

Asset turnover = Sales / Assets

Let us take up an example to understand this well. Suppose company 'A' has assets worth Rs 10 bn on its books. At the end of the year, the company recorded a topline of Rs 25 bn. That means the company has an asset turnover of 2.5. This indirectly gives an indication that the company would be able to increase its revenues by Rs 2.5 with every rupee invested in as assets.

Naturally, the higher the assets turnover, the better it is for a company. However, it largely depends on the strategy a company is following. It is likely that a company with lower margins and higher volumes will have a higher asset turnover than a company involved in a low volume - high margin business.

Debt/Equity ratio - This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. As mentioned in the earlier part of this series, a company can broadly have two sources for employing funds into its business - from the owners and from third parties, i.e. loan funds.

As such, to get an idea as to how much of the funds employed into a business is in the form of loans, we use the debt to equity ratio. It is calculated by dividing the debt by the shareholders funds (or equity). As such,

Debt to equity ratio = Debt on books / Shareholders funds (Equity)

This ratio is probably one of the most observed ratios as it indicates the extent to which a company's management is willing to fund its operation with debt. Naturally, a high debt to equity ratio is considered bad for a company as it would have to pay the necessary interest on the borrowings.

But that does not make companies that have a certain amount of debt a bad investment. If a company is easily able to cover its interest costs within a particular period, it could be a safe bet. For the same, one should also gauge at the interest coverage ratio.

Interest coverage ratio - The interest coverage ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. As such,

Interest coverage ratio = EBIT/ Interest expense

For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20 m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the greater are the risks.

We hope that the series of articles so far would have helped you analyse companies' numbers better. In the next article of this series, we shall take up the topic of cash flows.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article


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1 Responses to "Financial statements: Key ratios"

madhusudan

Oct 2, 2009

dear editor,
i used your Equitymaster via web. i am very new to this .your suggestion are very use full.this will help me lot in future . thanks to all your team.

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