11) Understanding Financial Ratios

Companies despatch their annual reports once every accounting year (normally 12 months). With these reports running into hundreds of pages, how do you quickly understand a company's performance over this period? As accounts are prepared using the double-entry system, every item is linked to at least one other item.

Hence, understanding financial ratios would help profile a company. These ratios are broadly classified as leverage, liquidity, efficiency and profitability ratios. We shall first focus on the profitability ratios for, as investors, we are more concerned with the company's earnings than with its operational efficiency, capital structure or its ability to meet debt obligations.

Margin ratios

Margin ratios, one of the key measures of profitability, show the efficiency of the firm in retaining revenues. These can be classified further into gross margin, operating margin and net margin ratios.
The operating margin ratio is calculated by dividing the operating income (net sales minus production, administration and selling and distribution costs) by net sales. In other words, it is the percentage of revenue earned in excess of production, administration and selling and distribution costs. Realisations or billing rates and operating cost per unit are among the key factors that drive this ratio. Volumes, though not as pivotal as the earlier mentioned factors, also play a role.

The operating margin also serves as an indicator of the cost-competitiveness compared to peers where individual costs cannot be determined easily. For example, while India Cements has an operating margin of about 13 per cent, its peer, Madras Cements has about 15 per cent.
The net profit margin, another key measure of profitability, is calculated by dividing post-tax earnings by net sales. It is the percentage of revenue that accrues to the owners of the entity. This ratio is a function of the operating margin, interest coverage and the rate of incidence of tax.

While high margins are desirable, as they provide a cushion against the risk of adverse changes, investors need to look at the structure of the margins to determine the sustainability and scope for improvement.

A significantly high margin needs to be treated with caution as threats from new entrants and substitute products are higher. Tendency to hike capacities, leading to overcapacity, is also more; the recent trend in the caustic soda industry is case in point.

While the above two measures of profitability are derived from the income statement (simply, the profit-and-loss account) the following two return ratios are derived from both the income statement and the balance-sheet.

Return on capital employed

This ratio indicates the profitability of an entity's capital investments. Why does this ratio matter to an investor? If this ratio is lower than the rate at which the company borrows, any further rise in debt will lead to negative earnings growth.

Return on Net worth

This ratio indicates an entity's profitability and efficiency, and is arrived at by dividing earnings after taxes by the shareholder's funds. This ratio, a combination of three underlying factors, is related to profit margin, asset management, and leverage. When an investor goes by the price-to-book value measure, he should consider this ratio as it aids in measuring the rate at which a company improves its shareholder funds.

Although a high RONW is desirable, the stability of this ratio plays a significant role. A key reason for the steady run-up in the price of Infosys Technologies is the fact that the company has recorded an average RONW of 40 per cent over the past five years. This would indicate that the company has grown more than four-fold in this period.