Loading

Alison's New App is now available on iOS and Android! Download Now

Module 1: Ratio Analysis and Return on Equity

Study Reminders
Support
Text Version

Set your study reminders

We will email you at these times to remind you to study.
  • Monday

    -

    7am

    +

    Tuesday

    -

    7am

    +

    Wednesday

    -

    7am

    +

    Thursday

    -

    7am

    +

    Friday

    -

    7am

    +

    Saturday

    -

    7am

    +

    Sunday

    -

    7am

    +

Namaste.In last two sessions we have been discussing about Analysis and Interpretation of financialstatements.We have already discussed that raw data in itself is not much useful it needs to be analysedfrom the view point of a particular stakeholder, then it becomes far more useful it becomescomparable and it can be also used for projections.We have also discussed that we can do horizontal as well as vertical analysis, but the mostimportant type of analysis is ratio analysis and large number of ratios can be calculatedserving variety of purposes.In our early sessions we had started the discussion on liquidity ratios, then capital structureas well as you have also discussed the activity ratios.Do you remember: what is liquidity ratios stand for?These are also known as working capital ratios because they tell you about availability offunds for day to day management of the business.So, which are the important ratios in the category?The first one is current ratio perhaps the most important ratio and very often used byvariety of users where we compare the relationship of current assets to current liabilities.So, for day to day transactions this is very important, so for taking a decision of givingcredit often suppliers will look at the current ratio of the customer to see whether customerwill be able to repay the debt in the repay that particular debt in time.It is also seen by bankers, it is also useful for internal management to see how is theworking capital management of the company.The other liquidity ratio was quick ratio which is more conservative way of calculatingcurrent ratio.Then going to capital structure or leverage ratios we had seen that long term funds canbe obtained from two ways: one is equity that is owners fund, the other is debt.Now, capital structure is a mixture of in what percentage you debt equity versus whatpercentage you can debt you have you can raise the debt, it can be 100 versus 0 that willbe called as no debt or all equity company.In such a scenario the risk is less, the stability of the company is more because debt leadsto possibility of liquidation because firm has to pay interest and instalment on certaindue date.But, having less debt affects our returns or profitability to some extent that is whya good mix is required between debt and equity.One of the most important ratios in this segment is debt equity ratio which is extensivelyused by lenders or bankers.They decide as to what debt equity ratio is acceptable, it is also useful and is usedby long term investors; in case of M and A or such deals also this ratio plays an importantrole.The next type of ratios are known as activity ratios they are also known as turnover orefficiency ratios.So, here we see how efficiently an asset being used for example, if you have fixed assetsof let us say 1 crore how much revenue we are able to generate from them.Suppose, we can generate a revenue of 4 crore it will mean turnover of 4 crore divided byfixed assets of 1 crore giving a ratio of 4; 4 is to 1 that is known as fixed assetturnover ratio, very important ratio to know the utilisation of fixed asset.This ratio is also useful and similar ratio is also calculated for working capital turnover.Now, within working capital you can know the efficiency in management of each of the currentassets.So, what ratio do you calculate for it do you remember?We calculate debtors turnover ratio which is sales upon debtors, but we need to refineit a bit because debtors or receivables are mainly from credit sales.So, we can refine it a bit and say it call it as credit sales upon average debtors; sameway it can be cost of sales upon average stock or average inventory for inventory turnoverratio.Now, both these ratios I will just show you the ratios for more clarity.So, we were here working capital turnover ratio which is sales upon working capital.For inventory turnover we take cost of sales because, the inventory is at cost insteadof sales generally better ratio would be cost of sales divided by average inventory.Now, this ratio can also be represented in terms of number of days, then it is calledas a stock holding period.So, we take average inventory divide it by cost of sales and multiplied by 365 or multiplyit by 12; if you want to know it in terms of months.So, this is the stock holding period, same way for debtors we can calculate debtors turnoverratio we can also calculate debtors velocity that is number of days of debtors.Now, this is useful for knowing how well the company is managing inventory or debtors,we can compare it with their standard credit policy that for how many days they are givingcredit; let us say as per policy they give credit for 30 days, but the ratio is 33 itwill mean that they are slightly slow in collection.If the ratio is much more let us say the ratio is 50 versus standard of 30 it will mean thatthey are very slow in collection, it can also mean from audit angle or from investigationangle that there is a possibility of some over statement of debtors.Then we will go for aging schedule or some more techniques to know the components inthe debtors or how long those receivables are pending to be collected; like that theseratios are of more used for the management of the company.We also have creditor’s turnover ratio that is credit purchase upon average accounts payable.We can also calculate creditor’s velocity that is company takes how many days to makethe credit a make the payment.We also know that how many days the company is getting credit.So, in a way we know what is the reputation of the company in the market, are they gettingany credit.So, that if we want to take a credit decision we can know the credit period for the customerwhich other people are giving that particular party.Now, let us go with this I think a turnover ratios is clear to you.Now, we will go to the next type of ratios they are known as profitability ratios.In fact, our discussion on the ratio itself we had started with this ratio that is knownas net profit ratios.These ratios are also known as P and L ratios because both numerator and denominator weare getting from P and L and as the name suggest we know about the profitability of the businessin relation to the turnover generated or in relation to sales ok.So, one of the important ratios is net profit ratio, net profit upon sales you can alsotake net profit before tax, but more common is the final profit that is net profit aftertax divided by sales.If you want to know the gross ratio, then we go for gross profit ratio which is grossprofit upon sales this is also known as gross margin.Now, both this now this particular ratio instead of finding for the whole company it can becalculated for a particular division or particular range of products or sometimes on a singleproduct.So, that we know that from that product how much is a gross profit generated, see grossprofit is more linked to sales because for calculating net profit we charge various otherthings which could be fixed charges.But, gross profit is mainly related to sales that is why gross margin or GP ratio is verymuch useful to know the profitability of a particular segment.We can compare this ratio with other players in the market, so that we know are our pricesbeing fixed a properly do we have in a profitability, do we have more profitability are we overchargingis there a scope for reducing the price to increase the sales or are we underchargingthat is our margins are too thin as like that various calculations can be done using grossprofit margin or gross profit ratio.It can also be calculated at a operating profit level where in it is operating profit uponsales.So, we will know the profitability of our operations from the sale.Now, within profitability ratios there are other ratios which are known as return ratiosthis is profitability in the context of capital employed or resources used by the undertaking.The earlier profitability ratios they were profitability in relation to sales, but forthe investor what is more important will be the money put by him or her and what returnthe company is able to generate those ratios are profitability.So, one of the important ratios is return on equity as the name suggests this is themost important ratio from the owners view point because owners want to know how muchmoney they have put and what return they are able to get from the company for that profitafter tax upon net worth is a usual formula, net worth you know is also known as equity.So, we can also say profit after tax upon equity or we can say profit after tax uponowner’s fund.Now, this ratio is very important because owners will know the return from a particularcompany, they can compare this ROE across different companies or for the whole market,so as to choose which company they can invest in.Now, the other important ratio even more important I would say is known as ROI Return on Investment,it can also be called as return on capital employed.Now, in the in the numerator we write return and in the denominator we write capital employed;that means, capital which is invested sometimes it is also known as return on invested capital.Now, what is a written here?Written refers to profit, but it may not be profit after tax we may often take profitbefore tax and add back interest.Because remember in the denominator we are writing total capital employed in the firstratio that is ratio a we had taken only owners fund in the denominator.But, in ratio b the denominator capital employed includes equity plus debt that is all firstused since the denominator has debt numerator also we need to add interest.So, we take profit after tax, add back tax, add interest many times we make adjustmentfor non trading or non operating income because we were using this ratio to know the returnsfrom that particular business activity or that particular company.So, if there are any non operating items they can be removed and we will calculate the returnrelated to that particular business.Now, this ratio can be calculated for the whole company, but it can also be calculatedfor a particular segment of business.Like for example, one factory or one plant, it can be calculated for one project.Now, this is used by investors to know the return it is also a very much used in projectmanagement.In fact, most of the project decisions are driven by ROI, before deciding any projectyou have to make projection and find out how much is the return expected from that project.So, if company wants to invest 50 crore in some project it must know how much returnit is likely to get suppose that return let us say is 10 percent.So, we will invest 50 crore and we are likely to get 50 lakhs it is 50 lakhs by 50 crorewhich is just 1 percent, then definitely we will not be interested.If we are getting 5 crore on a return on investment of 50 crore it becomes a return of 10 percentperhaps steel company may not be interested if their cost of funds is say 12 percent andthe project is giving only 10 percent then it is not worth to enter that particular businessSo, viability of a project very much depends on ROI generated by the project.Now, this ratio not only for the company even in the individual life it is useful.Suppose you are taking the decision to purchase some asset or if you are taking a decisionto go for higher education it will be good for you to know the ROI on your investmentbecause you are investing money you are investing your time.So, how much return it is likely to generate becomes useful.So, this ratio is extensively used in different types by different types of users from theinvestors at to the company as they themselves want to start a new project ok.Now, the next one here the definition of capital employed also you see.Now, this is a broad base all the money used, so we are adding equity that is owners fundplus preference capital plus reserves and surplus plus debentures or any long term debts,if there are any miscellaneous expenses or non trade investments they are usually removed.Because if you are putting some money outside business return on that investment can beseparately calculated, here it is good to remove it from the denominator.And, in the numerator also you can see that is why we have reduced non trade adjustmentare you getting ok.Now, let us go to another formula of calculating ROI, we have already seen turnover ratioswe have already seen profitability ratios.Now, one way of calculating TOI is by multiplying the profitability into capital turnover,If you remember capital turnover had sales in the numerator divided by capital employedand profitability had PAT upon sales.So, if you multiply both you will get profit upon capital employed which is precisely whatis ROI are you getting.Now, there can be some variations like one can take operating profit ratio or one cantake net profit before tax ratio and so on.Now, the next ratio in the return ratios is return on assets.Now, we are using fixed assets or some any asset, so we can take that particular assetin the denominator and find out the profit generated by that asset.So, net profit after tax here it need not be the net profit of the whole company, itcan be the profit from that particular plant or that particular activity divided by averagefixed assets this is bit of improved one because instead of taking yearend figures we havetaken average figures.See in the in the numerator the profit is calculated for the whole year, so it makessense to instead of taking the closing take the average fixed assets.Now, this can be calculated for different assets you can instead of fixed assets youcan also take average total assets if you want to know the return on total assets.So, now, from return ratios we will go to next ratio which is in a way a return ratio,but this is extremely important from stock market angle known as earning per share.We can calculate the net profit from net profit, if there are any payments to be made to preferenceshareholders extra they removed.So, that we know the profit available for the equity owners and we will divide it bynumber of shares.Now, this is very important because if you tell somebody that total net profit of ourcompany is let us say 1300 crores.Now, shareholder does not know what exactly he or she gets on his or her own shares.So, instead of telling 1300 crores, if you divide it by number of shares you will geta more understandable figure.Let us say it comes to 150 rupees per share, then it becomes very simple to understandthat is why in stock market parlance EPS plays a very important role.Whenever any data is reported about the share like market price it is immediately comparedwith earning per share as to what that share is able to earn for the shareholders or forthe owners.Now, from this EPS some market related ratios like PE ratio are calculated where we comparethe market price with earning per share are you getting.So, this is very important ratio in the stock market from the investor’s angle especiallyfrom small investor’s angle.Now, from EPS as I told you we are able to calculate PE ratio price earning ratio.Now, in the numerator we have taken market price per share and divided it by earningper share.Now, what will this ratio tell you?Suppose earning per share of a particular company is 10 rupees and it has a market priceof 150 rupees, so 150 upon 10 it means 15 times it is earning is the market price.Now, what does it tell you, is it good to have high or PE ratio or low PE ratio?As of now PE ratio of Indian market now instead of taking one company average PE is calculatedfor the whole capital market.Currently capital market has a average PE of around 25.Now, suppose company has a PE ratio of 15 is it a good or bad sign?Perhaps for a new investor it is a good sign because while other shares are putting at25 PE we are getting this particular share at a 15 PE.That means, it is comparatively available at a lesser price it could be a good bye ofcourse, such decisions should not be taken only by PE I am just giving an example becausewe will have to study other aspects.But as far as the PE is concerned for a fresh investors it shows that the price of the shareis relatively low which is a good sign from a buying angle, but from the company's angleit reflects upon the goodwill of the company when other companies in the market are ableto command a PE of 25, if our company has a PE of only 15; that means, this companyis not much respected by the market either its earnings are not considered very reliableor market feel that the future is not very good that is why PE ratio could be low.Whereas for some company if PE ratio is high let us say company b has a PE ratio of 50while the market PE is 25; that means, this company has a higher recognition in the market.So, in stock market parlance PE ratio is very important whenever a price is quoted normallyPE is also quoted for that share.Now, will this ratio change every year or will it change every day?Now, this is one ratio which will change every day not only everyday it will change everyminute.Because numerator that is market price changes every minute denominator may change only onyearly basis, suppose the results are balance sheet P and L etcetera prepared at the endof the year you will get EPS only at the end of the year or all earlier ratios which wecalculated they would be yearly most of the companies declared their results quarterly.So, you will be able to calculate the ratios for each quarter, but as far as PE is concernedyou can calculate these ratio every minute as the market is moving the PE ratio willalso keep improving itself.These two ratios are very important, so we devoted little more time I will request youhave already have a company and if you have seen the annual report go to some stock marketwebsite look at the market price of the share and calculate the PE ratio mostly in the sidePE ratio will also be given that will give you market flavour.All earlier ratios where only financial statement ratios, this is related to what is happeningin the market.There are one or two more ratios which are useful for stock market or for investors thatis known as dividend per share.Now, in the numerator we take dividend, so that we know how much is a dividend paid bythe company on per share basis.So, dividend distributed upon number of shares.Now, we have seen variety of ratios either for liquidity or for profitability or forreturn then from stock market angle.Now, many of these ratios can be used in combination and that will give you good insight aboutthe performance or stability of the company, it can also be used for other purposes byvarious stakeholders.In the next session, we will be calculating the ratios and try to interpret them takingreal data from the actual company.So, I will request you to revise whatever ratios we have done right.Now let us stop.Namaste.Thank you.