Introduction to Ratio Analysis (Part-1)

Ratio analysis-a health report

Absolute numbers do not speak much. Ratios are calculated from absolute numbers of the financial statements bringing out the hidden meanings. 

Haven’t we heard about the CBC report-a complete blood count report recommended for our health check-ups by doctors? There are various parameters in a CBC report that identifies problem areas or potential health problems. Ratio analysis does a similar thing. Ratios analyse the potential financial health of a company by measuring its efficiency, profitability and financial risks.

A healthy company must have efficient assets, profitable operations and long-term sustainability.

Benefits of ratio analysis

The benefits of ratio analysis are many

• Financial performance: Ratios help in understanding the performance trend of the company over some time. A trend analysis of various ratios like gross profit ratio, operating profit ratio and net profit ratios will provide insights into the profitability of the company over the years. 

• Operational efficiency:  Ratios measure how well the resources of the company has been used. Ratios like inventory turnover and asset turnover ratios are helpful in this regard.

• Identifying financial risk: Ratios help the management identify areas of weakness and take corrective actions. Ratios like interest coverage, working capital cycle etc can help the management take corrective actions in the respective areas.

• Peer comparison: Ratio analysis helps in identifying the good, better and the best of companies within a sector. Peer analysis shows the relative position of a company with other members of the peer group.

Forecasting: Ratios of the past years can be used to forecast and project the future after adjusting for the present variables in hand.

Classification of ratios

Ratios can be broadly classified based on 

• Growth
• Operating performance
• Efficiency
• Financial soundness i.e., financial risk

Growth ratios

Growth ratios measure the progress of the company’s key business parameters like revenue, profits, dividend, earnings, assets etc. It helps in understanding the track record of a company. Growth should be analysed for a longer time. Given below are the growth parameters of a leading retailer. One can see the impact Covid-19 has had on the growth in sales and profits in March-21. One has to identify the cause of growth or de-growth in growth analysis.

Operating performance

The operating performance of a company can be classified into two categories; Profitability ratios and return ratios.

• Profitability ratios help in knowing how profitably the company has been operating. It is the ability to convert sales into profits. Growth in margins is as important as growth in absolute profits.  Broadly there are three ratios; gross margin, operating margin or EBIT and net margin. 

• Gross margin ratio (%)- This is also known as the gross profit ratio. Gross profit is calculated as Net sales- direct expenses.

Gross margin = gross profit/net sales

Interpretation: In the example, the company has tried to maintain its gross margin in the range of 18-21 per cent. Gross margins for March-21 were impacted due to covid-19.

Operating margin (%)- is the ratio of operating profit to sales. It is what a company earns on sales after deducting direct and indirect expenses like selling & distribution and administrative expenses. While the indirect expenses include depreciation it does not include interest and taxes. 

Interpretation: The company has been able to maintain an operating margin of 6 per cent despite covid. The range of operating margin is 5-8 per cent and is currently stagnating. However, the industry leader has improved his margins during the same period.

1. Net margin- This ratio is simply the net profit that remains after deducting all the expenses and including all the incomes. This ratio is measured in percentage. The profitability trend is to be seen for consistency. 

Net margin = Net profit after taxes/total income

Interpretation: The company is struggling at the net margins level. The net profit is trend is declining by 50 per cent since March-19. The industry leader has bettered his net margin.

1. 1. Return ratios- It helps in understanding the return to the shareholders and the return on total capital employed. Since shareholders are part owners of the company it is important to check the rate of return to the shareholders. Capital employed is the total funds deployed in the business. Capital employed is capital + free reserves+ borrowings. 

• Return on equity (RoE)- It indicates how efficiently the management is using the shareholder’s fund. It is expressed in percentages. This part of the profitability group of classification 

RoE = (Net Profit / average shareholders’ funds) x 100

Interpretation: The company’s net profit has been contracting. The net profit is trend is declining by 50 per cent since March-19. The industry leader has bettered his return on equity to 16.2%

1. Return on capital employed (RoCE)- It measures what the company earns on the total capital it has employed. Capital employed is the sum of net worth, long-term debts and short-term debts. It can also be calculated as total assets minus the current liabilities. The higher the ratio better is the return. 

RoCE = earnings before interest and tax (EBIT)/average capital employed.

Interpretation: The return on capital employed has declined as compared to last year. The industry leader is way ahead in terms of return on capital employed.