9.1 - Overview on Financial Ratios

We have learned how to read financial statements over the last few chapters. Now, we will be focusing our attention on analyzing these financial statements. Studying the 'Financial ratios' is the best way to analyze financial statements. Benjamin Graham, also known as the father of fundamental analysis, popularized the theory of financial ratios. Financial ratios are used to interpret results and compare them with other years in the same industry.

To calculate a financial ratio's value, a typical one uses data from the financial statements. We need to know the attributes of financial ratios before we can understand them.

The financial ratio of a company is not enough information to be considered a good indicator. As an example, let's say Ultratech Cements Limited has 15% profit margin. How useful is this information? It's not that important. It is good to have a 15% profit margin, but how do I determine if it is the best?

Assume, however, that ACC Cement's profit margin of 12% is what you are seeing. Comparing two companies is a sensible way to compare their profitability. Ultratech Cements Limited appears to be the more profitable of the two. I want to emphasize that Financial Ratios is not a useful tool by itself. This ratio only makes sense if you compare it with another company of similar size, or when you examine the trend in financial ratios. To get the best inference, it is important to analyze the ratio once it has been computed.

Here are some things to keep in mind when computing ratios. Accounting policies can vary between companies and financial years. This fact should be known by a fundamental analyst who will adjust the data to calculate the financial ratio.

9.2 - The Financial Ratios

Financial ratios can be classified in a variety of ways, including -

1. Ratio of Profitability
2. Leverage Ratios
3. Valuation Ratios
4. Operating Ratios

The profitability ratiosThe analyst can use these ratios to measure the profitability of the company. These ratios show how profitable the company is in terms of generating profit. Management's ability to generate profits is also a sign of their competitiveness. A company's profitability is important because it allows for expansion of the business and pays dividends to shareholders.

The Leverage ratiosAlso known as solvency ratios/gearing ratios, these ratios measure the company's ability to sustain its day-to-day operations over the long-term. The company's leverage ratios indicate how much debt it uses to finance its growth. For a company to continue its operations, it must pay its bills and fulfill its obligations. Solvency ratios are a way to understand the company's sustainability over time and keep its obligations in perspective.

The Operating RatioThe 'Activity Ratio', also known as the 'Activity Ratio', measures how efficient a business is at converting its assets (both noncurrent and current) into revenue. This ratio allows us to assess how efficient the company's management is. This is why Operating Ratios can also be called the "Management Ratio".

Ratios, regardless of their category, convey a message. Usually, it is related to the company’s financial situation. The 'Profitability Ratio,' for example, can communicate the company's efficiency. This is typically measured by the 'Operating Rateio'. These ratios are difficult to classify because of the overlaps. The ratios are therefore classified'somewhat loosely.

9.3 - The Profitability Ratio

The following ratios will be examined under "The Profitability Ratio":

1. EBITDA Margin (Operating Margin)
   • EBITDA Growth (CAGR).
2. PAT Margin
   • PAT Growth (CAGR).
3. Return on Equity (ROE).
4. Return on Asset (ROA).
5. Return on Capital Employed

Margin EBITDA

Margin of Earnings Before Interest Tax Depreciation and Amortization (EBITDA).It indicates how efficient the management is. It indicates how efficient the company’s operating model. EBITDA Margin is a measure of how profitable the company is (in percentage terms). To get an idea of how efficient the management is in managing their expense, it's always a good idea to compare EBITDA margins of companies to gauge their efficiency.

First, calculate EBITDA Margin.

EBITDA = [Operating revenues - Operating expense][

Operating Revenues = [Total revenue - Other income]

Operating Expense = [Total Cost - Finance Costs - Depreciation and Amortization]

EBIDTA Margin = EBITDA / [Total Income - Other Income]

Following the example of Amara Raja Batteries Limited's EBITDA Margin calculation, FY14 will be as follows:

First, we calculate EBITDA. This is done as follows:

[Total Revenue-Other Income] - [Total Cost-Finance Cost - Amortization]

Note: Other income includes income from investments or other non-operational activities. It would be a mistake to include other income in EBITDA calculations. We must exclude Other Income from Total Revenues.

[3482 – 46] - [2942] - 0.7-65]

= [3436]- [2876]

= 560 Crores

The EBITDA Margin therefore is:

560 / 34336

16.3%

Two questions are for you at this point:

1. What does an EBITDA margin 16.3% and an EBITDA margin Rs.560 Crs indicate?
2. What is the EBITDA margin of 16.3%?

The first question is quite simple. A company with an EBITDA of Rs.560 Cros means it has retained Rs.560 crs from its operating revenues of Rs.3436 Cres. Also, this means that the company spent Rs.2876 Cros on its expenses out of Rs.3436 crore. The company spent 83.7% on its expenses, and retained 16.3% for its operations at the operational level.

Let's now move on to the 2ndQuestion, hopefully you shouldNotHave an answer.

This topic was discussed earlier in the previous chapter. A financial ratio by itself is not enough to provide much information. It is important to compare the trend with other peers in order to make sense of it. A 16.3% EBITDA margin is a poor indicator of information.

Let's look at Amara Raja’s EBITDA margin trends for the past 4 years (all numbers in Rs Crs except EBITDA Margin) to get a better understanding of the EBITDA marge.
 

ARBL appears to have maintained an EBITDA average of 15%. However, it's evident that the EBITDA margin has been increasing. This is a positive sign, as it shows consistency in management's operational capabilities.

The EBITDA in 2011 was Rs.257 Crs and the EBITDA in 2014 is Rs.560Crs. This is a four year period.Growth in EBITDA CAGRRates as high as 21%

We have already discussed the formula to calculate CAGR in module 1.

It is clear that both EBITDA margin growth and EBITDA margin are impressive. We don't know yet if it is the most effective. These numbers should be compared to other products in order to determine if it is the most effective. Exide batteries Limited would be the best choice for ARBL. I encourage you to compare your results for Exide.

PAT Margin

The EBITDA margin is calculated at an operating level. However, the Profit After Tax margin (PAT margin) is calculated at the final profitability levels. We only consider the operating expenses at the operating level. Other expenses like depreciation or finance costs are not taken into account. These expenses are not inclusive of tax expenses. To determine the company's overall profitability, we subtract all expenses from Total Revenues.

PAT Margin = [PAT/Total Incomes]

The Annual Report clearly states the PAT. ARBL's FY14 PAT is Rs.367 Crore on an overall revenue of Rs.3482 Cros (includes other income). This results in a margin of PAT of:

= 367 /3482

=10.5 %

This is the trend in PAT and margins for ARBL.Operating Revenues = [Total revenue - Other income]y

Financial Leverage = Average Total Assets/Average Shareholders Equity

The average assets are Rs.1955. It is only necessary to examine the shareholder's equity. We will also consider the "Average assets" rather than just the current-year assets for similar reasons.

Shareholders Equity FY13 = Rs.1059 Crores

Equity Shareholders for FY14 = Rs.1362 Crs

Average shareholder equity = Rs.1211 Crs

Financial Leverage = 1955 / 1211

=1.61 Times

ARBL's low debt makes Financial Leverage (1.61) a very encouraging number. ARBL supports Rs.1.61 for every Rs.1 Equity.

Now that we have all the information needed to calculate RoE ARBL, we can now do the same.

RoE =
Net Profit Margin (NPM)  X Asset Turnover X Financial Leverage

9.2% * 1.75* 1.61

25.9%It was quite impressive, I have to say!

Although this method is not the quickest, it is the most accurate. It allows us to gain valuable insight into the business. The DuPont model does not just answer the question of what the return is, but also how high it is.

If you want to quickly calculate RoE, here's how:

RoE = Net Profits/Avg shareholders Equity

We know that the FY14 PAT was Rs.367 Cr.

RoE = 367/1211

= 30.31%

Return on Asset (RoA).

Understanding the DuPont Model should make it easy to understand the next two ratios. The entity's ability use assets to generate profits to make a profit is called Return on Assets (RoA). Investments in non-productive assets are limited when a well-managed entity is managed. RoA is a measure of the management's ability to efficiently deploy its assets. It is obvious that the ROA score is more important than the ROA.

RoA = [Net income + interest*(1-tax rate)] / Total Average Assets

We know this from the Annual Report:

Net income for FY 14 = Rs.367.4 Crs

We also know that the total average assets for FY13 and FY14 are Rs.1955 crore according to the Dupont Model.
 

What does that mean? Interest * (1-tax rate)What does this mean? Think about it. The company's loan is also used for the acquisition of assets which, in turn, is used to generate profit. In a sense, debtholders are entities that have provided a loan to the business. In this way, the interest that is paid out to the company also belongs to a stakeholder. A 'tax shield' is a benefit that allows the company to pay lower taxes when interest is paid. We need to calculate the ROA by adding interest (by accounting tax shield).

The interest amount (finance costs) is Rs.7 Crs accounting for the tax protection it would be

= 7* (1-32%)

= 4.76 Cr. Note that the average tax rate is 32%

ROA is -.

RoA = [367.4 +4.76] / 1955

372.16/55

19.03%

Return on Capital Employed

The company's profitability is determined by the amount of capital it uses.

Total capital can include equity and debt, both long-term and short-term.

ROCE = [Profit Before Interest & Taxes/Overall Capital Employed]

Total Capital Employed = Short-term Debt + Long-Term Debt + Equity

We know this from the ARBL Annual Report:

Dividend before interest and taxes = Rs.537.7 Crs

Total Capital Employed

Short term debt: Rs.8.3 Cr

Long-term borrowing: Rs. 75.9 Cr

Equity of shareholders = Rs.1362 Cr

Total capital employed: 8.3 + 74.9 + 1362 = 14426.2 Crs

ROCE = 537.7/1446.2

= 37.18%

To Summarize

1. A financial ratio is an important financial metric for a company. The ratio is not a useful metric by itself. It conveys very little information.
2. To form an opinion, it is best to examine the recent trends in the ratio or to compare it to the company's peers.
3. Financial ratios can be divided into four categories: 'Profitability, Leverage, ’Valuation, and 'Operating'. Each category gives an analyst a different view of the company's business.
4. EBITDA refers to the net amount that the company makes after deducting its operational expenses from operating revenue.
5. EBITDA margin is the percentage of profitability at the operating level.
6. The firm's overall profitability is determined by the PAT margin
7. It is a very important ratio. It shows how much the shareholders have made on their initial investment in the company.
8. High ROE and high levels of debt are not good indicators.
9. The DuPont Model allows you to break down the ROE into various parts. Each part sheds light on different aspects.
10. The DuPont method is the most reliable way to calculate the ROE for a company
11. The return on assets is an indicator of how efficient the company uses its assets
12. The Return on Capital employed is the total return that the company receives from both equity and debt.
13. To make the ratios useful, they should be compared with other companies in the industry.
14. Additionally, it is important to analyze ratios at both a single time point and as an indicator for broader trends over time.