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Ratios are a quicker way to understand a company's performance, rather than poring over pages of accounts and notes and schedules in the annual report. Here's a detailed look.
PROFITABILITY RATIOS/ RETURN ON CAPITAL EMPLOYED
Are the operations efficient enough to generate profits? Creditors and shareholders alike are worried about this aspect. The former can be repaid only when the company is able to generate income from its operations, and for the latter, it broadly indicates the likely return they can earn on their investments. The profitability ratio is calculated as: (Profit before interest and taxes/capital employed) x 100. Capital employed is share capital + reserve and surplus + long-term liabilities - (non-business assets + fictitious assets).
COVERAGE RATIOS
Will the profits be enough to pay interest on loan or repay the amount? This is where the ‘fixed interest cover' and ‘debt service coverage' (DSCR) ratios come in. Calculated as PBIT/ Interest charges, the higher the fixed interest cover, the better. A comfortable interest cover would be at least two-three times.
To find out whether a company can repay the principal portion of its loan on time, the DSCR is calculated thus - PBIT/interest + (principal payment instalment / (1 – tax rate)). A DSCR of over 1 is considered appropriate. But here again, the higher the coverage, the better.
TURNOVER RATIOS
The speed at which capital employed in the business rotates or is unlocked is another indicator of profitability. The ‘fixed assets turnover' ratio (net sales/ net fixed assets) shows how muchinvestment in fixed assets contribute towards sales. Ditto for working capital ratios. High volume of sales with a relatively low working capital is an indicator of efficiency.
Credit sales/average accounts receivable will give the debtors turnover ratio. Say the turnover is three times. Using this, we can calculate the collection period (months in a year/debtor's turnover) as 12/3 = 4 months. This collection period indicates the promptness or the lack of it in money collection. Generally, the receivables should not exceed three-four months of credit sales. Such calculations can also be made for creditors.
Similarly, a high inventory turnover (cost of goods sold/average inventory) ratio indicates good sales. A low ratio indicates that money is locked up in stocks. The working capital ratios are useful in determining the company's ability to generate future cash flows from operations.
FINANCIAL RATIOS
Liquidity and debt-equity ratios are widely used financial ratios. Liquidity ratio, also called the ‘short-term solvency' ratio shows the adequacy or otherwise of working capital for a company's day-to-day operations. It is calculated as current assets/current liabilities. An ideal current ratio would be 2, indicating that even if the current assets are to be reduced by half, the creditors will be able to able to get their money in full. But a lot depends on the composition of current assets. If a substantial portion of the current assets is made of slow-moving/obsolete stocks or if the debtors comprise ageing debts, the company may not be able to pay the creditors even if the current ratio is higher than 2.
The debt-equity ratio is calculated as total long-term debt/shareholders' funds. It is considered ideal if the ratio is 1. This ratio shows the extent of owners' stake in the business as also the extent to which firm depends upon outsiders for existence
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