How to Analyse Financial Ratios

Investing in stocks is like owning a part of the business.

If you want to be successful in business, you must know how to read a financial statement and draw a conclusion about the financial health and potential of a business.

Know More:  How to Analyse Financial Statements of a Company

Analysing a company on a standalone basis may not have any relevance so it is always advisable to make an interfirm and intrafirm comparison.

Read More:  How To Do An Industry Analysis

When you come across a situation where you are comparing a company which is in an initial phase earning a revenue of Rs 50 crore and comparing it with a matured company earning revenue of Rs 5000 crore.

In such a scenario it is not an apple to apple comparison.

So in order to make the comparative analysis meaningful, financial ratio plays an important role.

The following are the list of key financial ratios you need to know to determine the financial health of a company:-

• Days Inventory Outstanding (DIO) or Inventory days–

It is calculated as-

DIO= (Average Inventory/COGS) x 365

It indicates an average time required by a company to convert its inventory into sales.

A DIO of 30 days indicates that the company held the stock for 30 days on an average before converting it to sales.

This ratio is industry specific and should be compared to peer companies to get the real picture.

Say DIO of 180 days may look horrible for a retail industry but the same figure is ideal in case of real estate sector.

The lower is the ratio, better is company’s efficiency and profitability.

A low DIO could be achieved either by tight inventory management (good) or by reducing prices (bad).

Say if company’s inventory has decreased and sales increased, indicates that company is able to sell its inventory.

On the other hand, if company’s inventory has increased and sales have come down, it shows that the company is not able to sell its product and hence it is pilling up

• Days Sales Outstanding (DSO) or Receivable days–

It is calculated as-

DSO= (Average Receivable/Sales) x 365

It indicates company’s collection period i.e. time taken by a company to convert its receivables into cash. A DIO of 30 days indicates that company takes 30 days on an average to receive payment on its credit sales.

A business capable of converting its receivables into cash quickly is a positive sign of company’s financial health and efficiency since cash is a king in business.

A lower DSO number is preferable which implies that it takes a company fewer days to collect its accounts receivable.

On the other hand, a high DSO number indicates that a company is selling its product to customers on credit and taking a long time to collect the money.

• Days Payable Outstanding (DPO) or Payable days–

It is calculated as-

DPO= (Average Payable/COGS) x 365

It measures the average number of days a company takes to make payment to its suppliers. It shows company’s payment policy.

A DPO of 30 days indicates that company takes 30 days on an average to make payment to suppliers over its credit purchase.

A company with higher days of payables than its competitors means the company is getting better credit terms from their vendors than its competitor.

Higher the number, better is company’s efficiency and shows company’s ability to delay payment and conserve cash.

Know More: Understanding the Concept of Cash Conversion Cycle

• Cash Conversion Cycle–

It measures the number of days which a company takes to convert its raw materials into final cash flow. It is also known as cash cycle.
It is calculated as-

Cash Conversion Cycle= DSO+DIO-DPO

It is a measure of management’s effectiveness i.e. how well a business manages its cash.

The lower the better and a great way to compare competitors.
watch the video below to get a better understanding of Cash Conversion Cycle :

• Debt Equity Ratio–

It is used to measure company’s financial leverage.

It’s a measure of the fund provided by outsiders to the fund financed by company’s insider (equity shareholder) to finance a company’s asset.

The lower the ratio, the more conservative is the financial structure of the company. It is also known as leverage or gearing.

However, it is important to look into the industry in which the company operates because it can be high in real estate or in capital-intensive businesses while low in companies like personal computer manufacturers.

Know more about Debt-to-Equity Ratio by watching the video below:

It should not be viewed on a standalone basis and thus a comparative analysis should be made.

Want to become an expert in Ratio Analysis? Enroll in: NSE Academy Certified Equity Research Analysis course on Elearnmarkets.com.

• Interest coverage ratio–

It’s a measure of company’s ability to fulfill its interest obligation on its debt in a timely manner.

It is calculated as-

Interest coverage ratio= EBIT/Interest charges

It’s an important tool to measure company’s ability to meet its debt obligation.

Higher the better.

Anything below 2.5x is a warning signal.

Know more about Interest Rate Coverage Ratio by watching the video below:

• Gross margin–

It is a profitability ratio which compares the gross margin of company’s business to net sales.

It is calculated as-

Gross margin(%)= (Revenue – Cost of Goods Sold)/ Revenue)x100

It shows company’s profitability which it generates after selling its inventory.

The higher the percentage, the more the company retains on every rupee of sales after meeting its cost.

Higher gross margin also reflects greater efficiency in converting raw material to income.

Want to know more about Gross Margin Ratio? Watch the video below:

• Operating margin–

It shows how much revenue is left after meeting its operating cost.

It is calculated as-

Operating margin(%)= (Operating income/revenue)x100

It is also known as operating profit margin or return on sales (ROS).

This ratio is important especially to creditors and investors as it shows how strong and profitable company’s operations are.

Say if a company receives 30% of its revenue from its operation indicates that company is running the business smoothly and efficiently.

• Return on Equity–

It measures the rate of return for its equity shareholders and is one of the most important criteria for evaluating management effectiveness.

It is calculated as-

ROE=Net Income/Shareholder’s equity

Higher ROE around 15-25% is generally considered good.

But in order to get more clearer picture, it’s important to break it down further to get deep insight into how the company achieves its ROE.

This can be achieved from DU Pont formula of ROE stated below-

ROE= Net profit margin x Asset turnover x Equity multiplier
=(Net Income/Sales)x(Sales/Total Asset)x(Total Asset/Shareholders Equity)

Read More: DuPont Analysis: Interpretation, Analysis, Formula, Calculator

Splitting the ROE into three parts makes it easier to understand changes in ROE over time.

For instance, if net margin increases, higher sales would add more money thus increasing its ROE.

Similarly if Asset turnover increases, the firm is able to generate more sales for every unit of asset owned, thus again increasing overall ROE.

Lastly, increase in financial leverage would indicate that firm is using more debt to finance its activities. So increase in the proportion of debt also leads to higher ROE.

However, it should be noted that if the firm increases it leverage too much, it would lead to increase in the cost of debt, thus decreasing its ROE.

• Free Cash Flow to Sales–

It informs you that what percentage of sales is converted directly to FCF.

Any company that has FCF/S ratio higher than 10% is generating good FCF.

It tells you that company is very profitable and has a strong set of operations.

Any company that can generate FCF smoothly is able to hand out dividend easily and reinvest and seek opportunities for further expansion and other important activities.

 It is important to look into these figures for a period of at least 3-5 years to get a better insight into the company.

However, peer comparison is also equally important.

Want to know more about Free Cash Flows to Sales? Watch the video below: 

Bottomline:

Most of the time these figures are not provided to us, so an investor should learn to calculate it so as to make his analysis more concrete. It is not easy to remember all the figures of financial statements, so a sophisticated investor talks in terms of these ratios. Hence it’s important to be financially literate by educating yourself and you can also learn to speak in ratios.