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Session 7: Ratio

Analysis (PART A)
By: Ujjawal Kumar (Founder – WealthCulture)

https://wealthculture.in/
Topics of discussion

▪ What is Ratio Analysis?


▪ Why use Ratio Analysis?
▪ Types of Ratios
▪ Profitability Ratios
▪ Efficiency Ratios
▪ Solvency Ratios

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Why study Financial Ratios? (1/2)
As a Research Analyst some of the questions that we need to answer about a business are:

▪ What is the financial situation of the business?

▪ Is the profitability improving or reducing?

▪ How efficient are the operations?

▪ What are the challenges that the business is facing? Is there a way to figure out these challenges?

▪ Is this Company A better than Company B and why?

▪ Should one invest in this business or should as a bank give loan to this business and how much?

And many more…………

Financial ratios help us evaluate any business and answer these questions

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Why study Financial Ratios? (2/2)

• Helps us make sense of Financial Statements

• Helps in Understanding the Profitability of the company

• Helps us analyze the Operational efficiency of the firms

• Helps us in identifying business risks of the firm

• Helps in identifying financial risks of the company

• To compare the performance of different firms

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What are the different types of ratios?

5 Types of Financial
Ratios

Profitability Efficiency Liquidity Solvency Valuations


Ratios Ratios Ratios Ratios Ratios

These ratios They reflect the They measure These ratios Measures how
measure overall firm’s efficiency the firm’s ability show the appropriately a
performance in utilizing the to meet current proportion of company is
and assets obligations debt and equity valued and what
effectiveness of in financing the type of return an
the firm firm’s assets investor may get

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Profitability Ratios
Intentionally Left Blank
Gross Margin Ratio

• The gross margin ratio, also known as the gross profit


margin ratio, is a profitability ratio that compares the
gross margin of a company to its revenue. It shows
how much profit a company makes after paying off its
cost of goods sold (COGS)

Points to note:
• Gross margin gets affected by product mix (High margin products/services vs. low margin products/services)
• Gross margin gets affected by increase in raw material prices and inability to pass on the price increase to end
customer
• De-valuation of inventory can have significant impact on Gross Margins

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Operating Profit Margin
• Operating profit margin is a profitability ratio
used to calculate the percentage of profit a
company produces from its operations, prior to
subtracting taxes and interest charges.
• It is calculated by dividing the operating profit by
total revenue and is expressed as a percentage.
The margin is also known as the EBIT (Earnings
Before Interest and Tax) margin.

Points to note:
• Operating margin is a combination of Gross margin and SG&A
• SG&A can be optimized with improvement in scale (operating leverage)
• In industries where there is intense competition, low cost player is able to survive and grow because they are able to
reduce the pricing and still be profitable. Eg. Coca Cola slashes prices from 15 to 10 in states where Reliance has
launched Campa Cola

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Net Profit Margin

• Net profit margin (also known as “profit margin”


or “net profit margin ratio”) is a financial ratio
used to calculate the percentage of profit a
company produces from its total revenue. It
measures the amount of net profit a company
obtains per dollar of revenue gained. The net
profit margin is equal to net profit (also known as
net income) divided by total revenue, expressed as
a percentage.

Points to note:
• Net profit margin can be manipulated by higher other income and extra-ordinary items (always adjust for these items
before you calculate the real PAT)

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Example Calculation – Neogen Chemicals

Gross Margin = (487.25 – (343.77-


68.80) )/487.25 = 43.5%

EBIT Margin= (57.07+19.08)/ 487.25


= 15.63%

PAT Margin= (44.63)/ 487.25 = 9.15%


Points to note

• A low margin ratio does not necessarily indicate a poorly performing company. It is important to
compare margin ratios between companies in the same industry rather than comparing them across
industries.

• Two types of analysis required to evaluate margins in a company


 Comparison against peers
 Comparison against its own history

• Try to assess how economies of scale, utilization levels can affect margins going forward. Setting up of
new capacity can lower margins in the short term

• Never believe the management

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Efficiency Ratios
Intentionally Left Blank
Accounts Receivable Turnover & Accounts
Receivable Days
• The accounts receivable turnover ratio,
sometimes known as the debtor’s turnover
ratio, measures the number of times over a
specific period that a company collects its
average accounts receivable.
• The accounts receivable turnover ratio can
also be manipulated to obtain the average
number of days it takes to collect credit sales
from customers, known as accounts
receivable days.

Points to note:
• Lower the accounts receivable, better it is
• One should evaluate whether the company is doing better than peers and also evaluate its own performance
historically

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Inventory Turnover Ratio & Inventory
Days
• The inventory turnover ratio measures how many
times a business sells and replaces its stock of goods
in a given period of time. This ratio looks at cost of
goods sold relative to average inventory in the
period.
• Inventory Turnover Days are the number of days on
average it takes to sell a stock of inventory. This
formula is derived using the previously mentioned
inventory turnover ratio. Like the inventory turnover
ratio, inventory turnover days is a measure of a
business’ efficiency.

Points to note:
• Higher Inventory turnover is better
• It means less money is blocked in inventory, which leads to higher cash flow situation

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Asset Turnover Ratio & Fixed Asset
Turnover Ratio
• The asset turnover ratio, also known as the total
asset turnover ratio, measures how efficient a
company uses its assets to generate sales. This
ratio looks at how many dollars in sales is
generated per dollar of total assets that the
company owns.

Points to note:
• High asset turnover means higher utilization of fixed assets
• Higher asset turnover will lead to higher profitability & return ratios

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Example Calculation – Neogen Chemicals

Accounts Receivable turnover =


487.25/109.50=4.44x

Accounts Receivable Days =


365/4.44= 82 days

Inventory turnover = (343.77-


68.80)/194.59= 1.41x

Inventory days = (365/1.41)= 259 days

Fixed Asset Turnover =


487.25/(281.78+3.19+0.16)=1.7x
Solvency Ratios
Intentionally Left Blank
Debt to Equity Ratio
• The debt-to-equity ratio is a leverage ratio that calculates
the proportion of total debt and liabilities versus total
shareholders’ equity.
• The ratio compares whether a company’s capital structure
utilizes more debt or equity financing.
• The ratio looks at total debt which consists of short-term
debt, long-term debt, and other fixed payment obligations
(such as capital leases).

Points to note:
• A higher debt-equity ratio indicates a levered firm – a firm that is financed with debt.
• Leverage has benefits such as tax deductions on interest expenses but also the risks associated with these expenses.
• Thus, leverage is preferable for companies with stable cash flows, but not for companies in decline or in cyclical industries.
The appropriate debt-to-equity ratio varies by industry.

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Equity Ratio

• The equity ratio is a leverage ratio that calculates the


proportion of total shareholders’ equity versus total
assets. The ratio determines the residual claim of
shareholders on a business. It determines what portion
of the business could be claimed by shareholder in a
liquidation event.

Points to note:
• Companies having a higher equity ratio also suggest that the company has less financing and debt service cost as a
higher proportion of assets are owned by equity shareholders.
• A company that has an equity ratio greater than 50% is called a conservative company, whereas a company that has this
ratio of less than 50% is called a leveraged firm.

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Debt Ratio
• The debt ratio, also known as the debt-to-asset ratio, is a
leverage ratio that indicates the percentage of assets that
are being financed with debt. The higher the ratio, the
greater the degree of leverage and financial risk.
• The debt ratio is commonly used by creditors to determine
the amount of debt in a company, the ability to repay its
debt, and whether additional loans will be extended to the
company. On the other hand, investors use the ratio to
make sure the company is solvent, have the ability to meet
current and future obligations, and can generate a return
on their investment.

Points to note:
• A ratio equal to one (=1) means that the company owns the same amount of liabilities as its assets. It indicates that the
company is highly leveraged.
• A ratio greater than one (>1) means the company owns more liabilities than it does assets. It indicates that the company
is extremely leveraged and highly risky to invest in or lend to.
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Example Calculation – Neogen Chemicals

Debt to Equity =
(121.52+76.20)/439.24= 0.45x

Equity Ratio =
439.24/799.26=0.55x

Debt Ratio =
(121.52+76.20)/799.26=0.24x
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support@wealthculture.in

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