Financial Ratios

Q. What are financial statements and what do they show?

Financial statements comprise the balance sheet, the statement of profit and loss, and the cash flow statement.
They provide some beneficial information.

● Balance Sheet – It provides a snapshot of what a company owns (assets – companies invest in assets to fulfil
their mission) and owes (liabilities & shareholders’ equity – how does a company finance those assets, by
either borrowing money or raising money from their owners/ shareholders), as well as the amount invested
by shareholders, as of the date of publication, and mirrors the financial position on a particular date in terms
of the structure of assets, liabilities, and owners’ equity. (Shareholders’ equity and net worth are
interchangeable terms)
● Statement of Profit & Loss – It reflects the ongoing operations of a firm. It shows how a company realises net
profit after considering all its revenues obtained and the cost incurred during the year.
● Cash Flow Statement (CFS) – It measures how well a company generates cash to pay its debt obligations,
fund its operating expenses, and fund investments.

Thus, the financial statements provide a summarised view of the financial position and operations of a firm.

Q. Why is the analysis of financial statements needed?

A basic limitation of financial statements is that they don’t give all the information related to the financial operations
of a firm. Hence, much can be learned about a firm from a careful examination of its financial statements as
performance reports.

The focus of financial analysis is on key figures in the financial statements and the significant relationship that exists
between them.

Investors and financial analysts rely on financial data to analyse the performance of a company and make predictions
about the future direction of the company's stock price. One of the most important resources of reliable and audited
financial data is the annual report, which contains the firm's financial statements.

Q. What do you mean by the analysis of financial statements?

The analysis of financial statements is a process of evaluating the relationship between component parts of financial
statements to obtain a better understanding of the firm’s position and performance.

1. The first task of the financial analyst is to select the information relevant to the decision under consideration
from the total information contained in the financial statements.
2. The second step is to arrange the information in a way to highlight significant relationships.
3. The final step is the interpretation and drawing of inferences and conclusions.

In brief, financial analysis is the process of selection, relation, and evaluation.

Q. What is ratio analysis?

The term ratio refers to the numerical or quantitative relationship between two items/variables.

Ratio analysis is defined as the systematic use of ratios to interpret financial statements so that the strengths and
weaknesses of a firm as well as its historical performance and current financial condition can be determined.
It can be used to compare the risk and return relationships of firms of different sizes. It should be noted that
computing the ratios does not add any information not already inherent in the above figures of profits and sales.
What the ratios do is that they reveal the relationship in a more meaningful way to enable equity investors,
management, and lenders to make better investment and credit decisions.

Why is ratio analysis used:

● It makes related information comparable. It makes interpretation possible because single figures in isolation
are meaningless, but when expressed in terms of a related figure, it yields significant inferences. For
instance, the fact that the net profits of a firm amount to, say, Rs 10 lakhs throws no light on its adequacy or
otherwise. The figure of net profit must be considered in relation to other variables. How does it stand in
relation to sales? What does it represent by way of return on total assets used or total capital employed? If
therefore, net profits are shown in terms of their relationship with items such as sales, assets, capital
employed, equity capital, and so on, meaningful conclusions can be drawn regarding their adequacy.
● Ratio analysis, thus, as a quantitative tool, enables analysts to draw quantitative answers to questions such
as: Are the net profits adequate? Are the assets being used efficiently? Is the firm solvent? Can the firm
meet its current obligations and so on?

Ratios deal with 4 questions:

1. How is the company doing in term of generating profits?

2. How efficient/ productive is the company?
3. How does it finance itself?
4. Liquidity – the ability of a company to generate cash quickly (If all the assets are in real estate, it is illiquid.
And if all the wealth is in the checking account, it is highly liquid).

How ratio analysis enables comparison: The use of ratios, as a tool of financial analysis, involves their comparison,
for a single ratio, like absolute figures, fails to reveal the true position. For example, if in the case of a firm, the
return on capital employed is 15 percent in a particular year, what does it indicate? Only if the figure is related to the
fact that in the preceding year, the relevant return was 12 percent or 18 percent, it can be inferred whether the
profitability of the firm has declined or improved.

● Trend ratios – They involve a comparison of the ratios of a firm over time, that is, present ratios are
compared with past ratios for the same firm. The comparison of the profitability of a firm, say, years 1
through 5 is an illustration of a trend ratio. Trend ratios indicate the direction of change in performance–
improvement, deterioration, or constancy–over the years.
● Interfirm comparison – It involves the comparison of the ratios of a firm with those of others in the same line
of business or for the industry reflects its performance in relation to its competitors. For example, if we
know that the return for the industry is 10 percent or 20 percent, the profitability of the firm in question can
be evaluated.

Q. What are the different types of ratios?

Ratios can be classified into six broad groups:

(i) Liquidity ratios,

(ii) Capital structure/leverage ratios,
(iii) Profitability ratios,
(iv) Activity/Efficiency ratios,
(v) Integrated analysis of ratios and
(vi) Growth ratios.
Q. What are liquidity ratios?

The liquidity ratios measure the ability of a firm to meet its short-term obligations with assets that can quickly be
converted into cash. Most companies go bankrupt because they run out of cash. Liquidity ratios measures this risk
and reflect the short-term financial strength/solvency of a firm.

Liquidity is a prerequisite for the very survival of a firm. The short-term creditors of the firm are interested in the
short-term solvency or liquidity of a firm. But liquidity implies, from the viewpoint of the utilization of the funds of
the firm, that funds are idle or they earn very little. A proper balance between the two contradictory requirements,
that is, liquidity and profitability, is required for efficient financial management.

In theory, therefore, the higher the liquidity ratios, the better the firm. But highly liquid assets, like cash and
marketable securities, may not provide much of a return.

The liquidity ratios are, no doubt, primarily relevant from the viewpoint of the firm's creditors.

Types of Liquidity Ratios:

1. Net working capital (NWC) – Working capital is the capital that companies use to fund their day-to-day
operations. It usually emphasizes 3 important components – accounts receivables, inventory, and accounts
payable.
Working Capital = current assets – current liabilities
working capital = short-term liquidity

● Current assets: They are the assets that in the normal course of business get converted into cash
without diminution in value over a short period, usually not exceeding one year or length of
operating/cash cycle whichever is more. Examples are cash and bank balances, marketable
securities; inventory of raw materials, semi-finished (work-in-progress) and finished goods
(inventories are the goods, and the associated inputs, held by a company that become those goods
that a company intends to sell and include raw materials, products that are being finished, and final
goods); debtors net of provision for bad and doubtful debts, bills receivable (accounts receivable are
amounts that a company expects to receive from its customers, typically other businesses, in the
future); and prepaid expenses.
● Current liabilities: These liabilities are short-term maturing obligations to be met in a short period,
normally a year. Examples are trade creditors, bills payable (accounts payable are the amounts a
company owes to suppliers), bank credit, provision for taxation, dividends payable, and outstanding
expenses.

Working capital = accounts receivable + inventories – accounts payable

To think about the consequences of working capital is to note that the daily operations of a company result
in an amount that needs to be financed, like any other asset. If the amount of working capital is lowered,
that lowers the financing need of a corporation. So, the way we manage working capital has deep financial
consequences.

Although NWC is not a ratio, it is frequently employed as a measure of a company’s liquidity position. An
enterprise should have sufficient NWC in order to be able to meet the claims of the creditors and the day-to-
day needs of the business. The greater the amount of NWC, the greater the liquidity of the firm. Accordingly,
NWC is a measure of liquidity. Inadequate working capital is the first sign of financial problems for a firm.
 Limitation of NWC: But since NWC is measured in absolute terms, a change in NWC does not necessarily
reflect a change in the liquidity position of a firm. For example, if the current assets in Year 1 are 100000 and
the current liabilities is 25000, then NWC = 100000 – 25000 = 75000. And in year 2 if the current assets are
200000 and current liabilities are 100000, then NWC = 200000 – 100000 = 100000. Effectively, although the
NWC has increased from 75000 to 100000, that is, by Rs 25,000 or 33.3% between two points of time, there
is a deterioration in the liquidity position. In the first year, the firm had Rs 4 of current assets for each rupee
of current liabilities; but by the end of the second year the number of current assets for each rupee of
current liabilities declined to Rs 2 only, that is, by 50%. For these reasons, NWC is not a satisfactory measure
of the liquidity of a firm for inter-firm comparison or for trend analysis. A better indicator is the current ratio.

2. Cash Conversion Cycle – A powerful way to frame the financing consequences of working capital is to frame
working capital temporally rather than monetarily. This framing is called the cash conversion cycle.
The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm.
The cash cycle captures the interrelationship of sales, collections from debtors, and payments to creditors.
Cash cycle = Inventory holding period + Debtors collection period – Creditors payment period
If companies pay before getting paid, they must finance the shortfalls in their cash conversion cycles. None
of this shows up in the measure of net profit or EBITDA. It is reflected in Operating Cash Flows in the cash
flow statement.

Asset performance refers to a business's ability to take operational resources, manage them, and produce
profitable returns. Analysts use metrics like the cash conversion cycle to compare and assess a company's
annual asset performance.

The gap in the cash conversion cycle raises several questions:

• How much is this gap going to cost to finance?
• How can the company change behaviours to reduce those costs?
• Will those changes cost more than the savings?

Example, a supplier encourages you to pay within 10 days instead of 30 days by offering a 2% discount – a
fairly typical offer. Is that a good deal? This is a financing decision and requires consideration of alternative
methods of financing. Since you’d be paying the supplier in 10 days instead of 30, you’d need to finance the
20-day gap. Who is a cheaper source of financing for those 20 days – the bank or the supplier? Let’s imagine
that the bank charges an annual interest rate of 12% per year, which would be <1% for 20 days of financing.
The discount offered by the supplier can be reframed as a financing cost for those 20 days; if you refuse the
discount, you give up 2% and you receive 20 days of financing, i.e., the supplier is charging you an implicit
interest rate of 2% for a 20-day loan. Would you rather pay 2% or <1% for a 20-day loan? The answer, of
course, is <1%. The bank financing is cheaper, you should take the deal from the supplier and borrow from
the bank to fund your cash conversion cycle for those 20 days.

As a rule, the shorter the cash cycle, the better the liquidity ratios as measured above, and vice versa.

Companies can reduce their financing gap by:

• Reducing the days inventory by stocking less inventory; company can be certain that the store will
sell out faster and it will need less financing. However, the danger is that if customers can’t find a
certain brand of product or kind of tool in the store, they will go to the rivals and may never come
back.
• Reducing the receivables collection period by extending less credit to customers. However, those
customers may need, or be used to receiving, credit from their suppliers; without it, they may prefer
to buy from the rivals.
 • Increasing the payables period – Paying suppliers late may erode relationships; they may become
reluctant to supply products or be less willing to extend credit. If a hurricane were threatening to hit
the city, and everyone needed more supplies, the vendors might be more interested in working with
the rivals than with the company.

Negative cash conversion cycle – Some companies actually manage their inventory, receivables, and
payables in such a way that they end up with what’s called negative working capital cycle, or negative cash
conversion cycle. The upshot is that their operations become a source of cash. They have working capital
cycles that allow them to grow rapidly without seeking external financing. Hence, the cash they generate
from their working capital becomes a powerful part of their business and financial model.
In effect, suppliers are financing their growth. The companies are substituting cheaper sources of financing
in the working capital cycle for external sources of financing. And that working capital consequence is a
powerful dimension of their economic returns, which are not captured in EBITDA, or EBIT, or net profit; it is
reflected in Operating Cash Flows in the cash flow statement.

Example, in a software-as-a-service (SaaS) business, which typically sells subscriptions, business customers
pay in advance and receive the use of software for the period they’ve paid for. The company will have a
negative receivables collection period because it gets paid before it provides services. It has no inventory,
and it will not pay suppliers immediately, creating a payables period. By taking payments first and then
providing services, the company is getting customers, in addition to their suppliers, to finance its operations.

Many companies use just in time manufacturing so they produce goods for sale only when needed. The
company first takes an order from the customer and then starts manufacturing the product, thus decreasing
its cash conversion cycle by lowering its days inventory and leading to a reduction in the financing costs of its
working capital.

A premium electric car manufacturer has started taking deposits from customers for future models. A
deposit may not be the full price of a car, but it still represents customer financing of the company’s
operations. By giving the company a deposit in advance of delivery, customers reduce the amount that the
company must rely on capital providers.

A negative working capital cycle that becomes less negative is no different from a positive working capital
cycle that gets longer.

3. Current Ratio – It is a measure of liquidity. It measures how easily a company can pay its short-term liabilities
with short term assets. It measures how well a company can pay its bills. Suppliers have the greatest interest
in a company’s current ratio because they’re the ones owed those bills.

Current Ratio = Current Assets

Current Liabilities

The current ratio of a firm measures its short-term solvency, that is, its ability to meet short-term
obligations. As a measure of short-term/current financial liquidity, it indicates the rupees of current assets
(cash balance and its potential source of cash) available for each rupee of current liability/obligation payable.

Current ratio asks the following questions on behalf of a company’s suppliers:

• Will this company be able to pay its suppliers if it needs to close?
• Will its current assets be sufficient to pay off its current liabilities (including those owed to
suppliers)?
Current ratio is a key way to think about if as supplier should extend credit to a company and if a company
will be able to survive the next 6 or 12 months.

Current ratio as a measure of margin of safety to the creditors: The higher the current ratio, the larger is the
amount of rupees available per rupee of current liability, the more is the firm’s ability to meet current
obligations and the greater is the safety of funds of short-term creditors.

● The need for safety margin arises from the inevitable unevenness in the flow of funds through the
current assets and liabilities account. If the flows were smooth and uniform each day so that inflows
exactly equalled absolutely maturing obligations, the requirement of a safety margin would be small.

● Moreover, the current liabilities can be settled only by making payment whereas the current assets
available to liquidate them are subject to shrinkage for various reasons, such as bad debts,
inventories becoming obsolete or unsaleable and occurrence of unexpected losses in marketable
securities and so on. The current ratio measures the size of the short-term liquidity ‘buffer.’ A
satisfactory current ratio would enable a firm to meet its obligations even when the value of the
current assets decline.

Interpretation of current ratio: In the case of company A in the above example, the current ratio is 1.5:1. The
current ratio of 3:1 for company B signifies that current assets are three-fold its short-term obligations. The
liquidity position, as measured by the current ratio, is better in the case of B as compared to A. This is
because the safety margin in the former (200 per cent) is substantially higher than in the latter (50 per cent).
A slight decline in the value of current assets will adversely affect the ability of firm A to meet its obligations
and, therefore, from the viewpoint of creditors, it is a riskier venture. In contrast, there is a sufficient cushion
in firm B and even with two-thirds shrinkage in the value of its assets, it will be able to meet its obligations in
full. For the creditors the firm is less risky. The interpretation is: in interfirm comparison, the firm with the
higher current ratio has better liquidity/short-term solvency.

Ideal current ratio: Although there is no hard and fast rule, conventionally, a current ratio of 2:1 (current
assets twice current liabilities) is considered satisfactory. The logic underlying the conventional rule is that
even with a drop-out of 50 per cent (half) in the value of current assets, a firm can meet its obligations, that
is, a 50 per cent margin of safety is assumed to be sufficient to ward off the worst of situations. The firm A of
our example, having a current ratio of 1.5:1, can be interpreted, on the basis of the conventional rule, to be
inadequately liquid from the point of view of its ability to always satisfy the claims of short-term creditors.
The firm B, of course, is sufficiently liquid as its current ratio is 3:1.

Very high current ratio: A very high current ratio may be indicative of slack management practices, as it
might signal excessive inventories for the current requirements and poor credit management in terms of
overextended accounts receivable. It indicates that the funds are lying ideal, which could’ve been invested
elsewhere to generate higher returns. High current and acid-test ratios would imply that funds have
unnecessarily accumulated and are not being profitably utilised. At the same time, the firm may not be
making full use of its current borrowing capacity. Therefore, a firm should have a reasonable current ratio.

Limitations of Current Ratio:

● One defect of the current ratio is that it fails to convey any information on the composition of the
current assets of a firm. A rupee of cash is considered equivalent to a rupee of inventory or
receivables. But it is not so. A rupee of cash is more readily available (i.e., more liquid) to meet
current obligations than a rupee of, say, inventory. Some of the current assets are more liquid than
others: cash is the most liquid of all; receivables are more liquid than inventories, the last being the
least liquid as they have to be sold before they are converted into receivables and, then, into cash. A
firm with a higher percentage of its current assets in the form of cash would be more liquid, in the
 sense of being able to meet obligations as and when they become due, than one with a higher
percentage of slow moving and unsaleable inventory and/or slow paying receivables even though
both have the same current ratio. In fact, the latter type of firm may encounter serious difficulties in
paying its bills even though it may have a current ratio of 2:1, whereas the former may do well with
a ratio lower than the conventional norm.
● A satisfactory measure of liquidity should consider the liquidity of the various current assets per se.
As already mentioned, while current liabilities are fixed in the sense that they have to be paid in full
in all circumstances, the current assets are subject to shrinkage in value, for example, possibility of
bad debts, unsalability of inventory and so on.
● Thus, the current ratio is not a conclusive index of the real liquidity of a firm. It fails to answer
questions, such as, how liquid are the receivables and the inventory? What effect does the omission
of inventory and prepaid expenses have on the liquidity of a firm?

4. Quick/ Acid-Test Ratio – The acid-test ratio is the ratio between quick current assets and current liabilities
and is calculated by dividing the quick assets by the current liabilities.
It is often referred to as quick ratio because it is a measurement of a firm’s ability to convert its current
assets quickly into cash in order to meet its current liabilities. Thus, it is a measure of quick or acid liquidity.
Quick Ratio = Current assets – (inventory + prepaid expenses)
Current liabilities
Quick assets: It refers to current assets which can be converted into cash immediately or at a short notice
without diminution of value. Included in this category of current assets are (i) cash and bank balances; (ii)
short-term marketable securities and (iii) debtors/receivables.
● The exclusion of inventory is based on the reasoning that it is not easily and readily convertible into
cash.
Inventory can be very risky in case there is no spot market available for the company to liquidate its
inventory. For example, a stylistic mistake on a new product in a luxury fashion house might make it
impossible for the company to sell that inventory, even at a discount. On the other hand, companies
that deal with products like steel, metals, etc. are more able to dispose off their inventory quickly
because they deal in materials that have a spot market. For companies with high-risk inventory, the
quick ratio provides a more sceptical view of their liquidity.
● Prepaid expenses by their very nature are not available to pay off current debts. They merely reduce
the amount of cash required in one period because of payment in a prior period.

Interpretation of quick ratio: The acid-test ratio is a rigorous measure of a firm’s ability to service short-term
liabilities. The usefulness of the ratio lies in the fact that it is widely accepted as the best available test of the
liquidity position of a firm. The acid-test ratio is superior to the current ratio. The interpretation that can be
placed on the current ratio (2:1) and acid-test (0.5:1) is that a large part of the current assets of the firm is
tied up in slow moving and unsaleable inventories and slow paying debts. The firm would find it difficult to
pay its current liabilities. The acid-test ratio provides, in a sense, a check on the liquidity position of a firm as
shown by its current ratio.

Ideal quick ratio: Generally, an acid-test ratio of 1:1 is considered satisfactory as a firm can easily meet all
current claims.

5. Super quick ratio – This ratio is calculated by dividing the super-quick assets by the current liabilities of a
firm. The super-quick current assets are cash and marketable securities.
This ratio is the most rigorous and conservative test of a firm’s liquidity position. Further, it is suggested that
it would be useful, for the management, if the liquidity measure also considers ‘reserve borrowing power’ as
 the firm’s real debt paying ability depends not only on cash resources available with it but also on its
capacity to borrow from the market at short notice.

6. Cash-Flow from Operations Ratio – This ratio measures liquidity of a firm by comparing actual cash flows
from operations (in lieu of current and potential cash inflows from CAs such as inventory and debtors) with
current liability.
Being a cash measure, the ratio does not encounter the problems of actual convertibility of current assets
(such as debtors and inventory) and the need for maintaining minimum levels of these assets. In general, the
higher the ratio, the better is a firm from the point of view of liquidity.

Q. What are Turnover/ Productivity/ Activity Ratios and how are they related to liquidity ratios?

From a finance perspective, increases in productivity mean you can squeeze more from less. Activity ratios measure
how well a company utilizes its assets to produce output. These ratios are also called efficiency ratios or asset
utilisation ratios. The efficiency with which the assets are used would be reflected in the speed and rapidity with
which assets are converted into sales. The greater is the rate of turnover or conversion, the more efficient is the
utilisation of assets, other things being equal. Over the long run, increases in productivity are the most important
contributor to economic growth.

Another way of examining the liquidity is to determine how quickly certain current assets are converted into cash.
The ratios to measure these are referred to as turnover ratios. In fact, liquidity ratios are not independent of activity
ratios. Poor debtor or inventory turnover ratios limit the usefulness of the current and acid-test ratios. Both
obsolete/unsaleable inventory and uncollectible debtors are unlikely to be sources of cash. Therefore, the liquidity
ratios should be examined in conjunction with relevant turnover ratios affecting liquidity.

Such ratios are also designated as turnover ratios. Turnover is the primary mode for measuring the extent of efficient
employment of assets by relating the assets to sales.

An activity ratio may, therefore, be defined as a test of the relationship between sales (more appropriately with cost
of sales) and the various assets of a firm. Depending upon the various types of assets, there are various types of
activity ratios.

Types of Turnover Ratios:

1. Inventory (or Stock) Turnover Ratio – The ratio indicates how fast inventory is sold. This ratio measures how
many times a company turns over (replaces) or sells all its inventory in a given year.
Inventory turnover = Cost of goods sold
Average inventory
● The cost of goods sold means sales minus gross profit.
● The average inventory refers to the simple average of the opening and closing inventory.

Interpretation: It is a test of efficient inventory management. To judge whether the ratio of a firm is
satisfactory or not, it should be compared over a period of time based on trend analysis. It can also be
compared with the level of other firms in that line of business as well as with industry average. In general,
the higher the number, the more effectively the company is managing its inventory as it sells products.
Because inventory is essentially a risky asset that needs to be financed, a higher inventory turnover is
financially valuable.
Example, retail stores differ in the way they turn over their inventory. Some turn over inventory really
quickly, others take a long time. A grocer turns over inventory faster. The grocery chain has perishable
goods, but given its selection of dry food, canned goods, and non-food items (such as light bulbs and paper
towels), its turnover would be considerably slower than that of a restaurant chain. Bookstore turns over
inventory really slowly, because it has inventory that ages relatively well and takes a long time to move.

Many service-based companies have some products to sell. For example, airlines and hotels are primarily
providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and
other items. These items are considered goods, and these companies certainly have inventories of such
goods. Both industries can list COGS on their income statements and claim them for tax purposes.
When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to higher than
the actual gross profit margin, and hence, an inflated net income.
Investors looking through a company’s financial statements can spot unscrupulous inventory accounting by
checking for inventory build-ups, such as inventory rising faster than revenue or total assets reported.
If the inventory value included in COGS is relatively high, then this will place downward pressure on the
company’s gross profit. For this reason, companies sometimes choose accounting methods that will produce
a lower COGS figure, to boost their reported profitability.
The balance sheet has an account called the current assets account. Under this account is an item called
inventory. The balance sheet only captures a company’s financial health at the end of an accounting period.
This means that the inventory value recorded under current assets is the ending inventory.
Some companies do not have inventories have nothing to sell because those companies likely provide
services. For example, a law firm, an advertising company, a medical practice, parcel delivery service,
social networking service, banks, airlines because the airlines’ primary line of business doesn’t involve
selling planes or spare parts as they transport people and that’s a service with no notion of inventory.
A department store chain would have a large amount of inventory, while an electric & gas utility
company has very little (electricity can’t be stored). Dell holds on to inventory for slightly more than 10
days, which matches its just-in-time business model, because it begins manufacturing only after it
takes orders, as a result it keeps inventory as low as possible.

High ratio: A high ratio implies good inventory management. A high ratio is good from the viewpoint of
liquidity and vice versa. Yet, a very high ratio calls for a careful analysis. An unusually high rate of inventory
turnover may indicate that a firm is losing business by failing to maintain an adequate level of inventory to
serve the customer’s needs. That is, there is a danger of the firm being out of stock and incurring high 'stock
out cost.' It is also likely that the firm may be following a policy of replenishing its stock in too many small
sizes. Apart from being costly, this policy may retard the production process as sufficient stock of materials
may not be available.

Low ratio: A very low inventory turnover ratio is dangerous. A low ratio would signify that inventory does not
sell fast and stays on the shelf or in the warehouse for a long time. It signifies excessive inventory or
overinvestment in inventory. Carrying excessive inventory involves cost in terms of interest on funds locked
up, rental of space, possible deterioration and so on. A low ratio may be the result of inferior quality goods,
overvaluation of closing inventory, stock of unsaleable/obsolete goods and deliberate excessive purchases in
anticipation of future increase in their prices and so on.

Ideal ratio: A firm should have neither too high nor too low inventory turnover. To avoid both 'stock out
costs' associated with a high ratio and the costs of carrying excessive inventory with a low ratio, what is
suggested is a reasonable level of this ratio. The firm would be well advised to maintain a close watch on the
trend of the ratio and significant deviations on either side should be thoroughly investigated to locate the
factors responsible for it.
 The computation of the turnover for the individual components of the inventory may be useful in this
context. Such ratios can be computed in respect of raw materials and work-in-progress.

Raw materials turnover = Cost of raw materials used

Average raw material inventory

Work-in-progress turnover = Cost of goods manufactured

Average work-in-progress inventory

Days Inventory – It shows the average number of days that the company holds inputs and goods. Dividing
the no. of days in a year (365) by the inventory turnover provides the average no. of days a piece of
inventory is kept inside a company before it is sold.
Days Inventory = 365
Inventory turnover

2. Receivables (Debtors) Turnover Ratio and Average Collection Period – It shows how quickly receivables or
debtors are converted into cash. In other words, the debtors turnover ratio is a test of the liquidity of the
debtors of a firm. The liquidity of a firm’s receivables can be examined in two ways:

(i) debtors/ turnover - The debtors turnover shows the relationship between credit sales and debtors of a
firm.
Debtor turnover = Net Credit sales
Average debtors + Average bills receivable (B/R)
● Net credit sales consist of gross credit sales minus returns, if any, from customers.
● Average debtors are the simple average of debtors (including bills receivable) at the beginning and at
the end of year.
Companies that sell to other companies, i.e., follow B2B (business-to-business) models have a higher
amount of their sales reflected in receivables; whereas companies that deal largely with consumers,
i.e., follow B2C (business-to-consumer) models have limited receivables. Banks own receivables that
take a long time to collect from customers (say 20 years on average), and a large fraction of their
financing comes from notes payable.

(ii) receivables collection period – It shows the average number of days it takes for customers to pay the
company. After a company sells its inventory, it needs to get paid for it. The lower this figure, the faster a
company is getting cash from its sales. It is the ratio for measuring the liquidity of a firm’s debtors. Example,
if a company gets paid in 7 days on average, it likely means it sells mostly to individuals; whereas if a
company takes a longer time to collect, it would suggest that it’s much more likely to be selling to other
businesses. Airlines sells to people like you and me, and we pay immediately. A parcel delivery service does
business with other companies as a logistics provider.
The companies that collect from customers quickly are retailers. Since retailers sell goods directly to
consumers, their receivables collection period is going to be short because customers pay immediately via
cash or credit. In contrast, businesses that do business with other businesses give credit of a minimum of 30
days. Grocery stores are more likely to get immediate payments. A significant fraction of drugstore revenues
may come from insurance companies, which would mean drugstores would become a bit like a B2B firm.
Receivables collection period (days) = 365
Debtors turnover

Interpretation: This ratio indicates the speed with which debtors/accounts receivable are being collected.
The analysis of the debtor’s turnover ratio supplements the information regarding the liquidity of one item
of current assets of the firm. The ratio measures how rapidly receivables are collected. A turnover ratio of 8
 signifies that debtors get converted into cash 8 times in a year. The collection period of 1.5 months or 45
days implies that debtors on an average are collected in 45 days. Thus, it is indicative of the efficiency of
trade credit management. The higher the turnover ratio and the shorter the average collection period, the
better is the trade credit management and the better is the liquidity of debtors, as short collection period
and high turnover ratio imply prompt payment on the part of debtors. On the other hand, low turnover ratio
and long collection period reflect delayed payments by debtors. In general, therefore, short collection period
(high turnover ratio) is preferable.
It is not, however, very prudent for a firm to have either a very short collection period or a very long one.

Low turnover ratio: A very long collection period would imply either poor credit selection or an inadequate
collection effort. The delay in the collection of receivables would mean that, apart from the interest cost
involved in maintaining a higher level of debtors, the liquidity position of the firm would be adversely
affected. Moreover, there is the likelihood of many accounts receivable becoming bad debts. If a company’s
receivables collection period is really out of whack with the rest of the industry, there could be a few causes
of this long collection period. The first is bad management that is not being aggressive about collecting the
cash owed to the company. Alternatively, it could be imprudently generous with credit to stimulate sales.
More dangerously, the company could have customers with outstanding debts that have been outstanding
for more than 200 days, with little likelihood of ever paying them. So, it might be a sign of hidden bad debt.

High turnover ratio: A high ratio is indicative of shorter time-lag between credit sales and cash collection. A
low ratio shows that debts are not being collected rapidly. But a rapid turnover of debtors may reflect strict
credit policies that hold revenue below levels that could be obtained by granting more liberal credit terms.
Similarly, too short a period of average collection or too high a turnover ratio is not necessarily good. While
it is true that it avoids the risk of receivables being bad debt as well as the burden of high interest on
outstanding debtors, it may have an adverse effect on the volume of sales of the firm. Sales may be confined
to only such customers as make prompt payments. The credit and collection policy of the firm may be very
restrictive. Without reasonable credit, sales will be severely curtailed.

Thus, a firm should have neither a very low nor a very high receivables turnover ratio; it should maintain it at
a reasonable level. The reasonableness of the collection period can be judged in either of the following two
ways.
First, the collection period of a firm can be compared with the industry practices of trade credit. Any notable
deviation may result from (i) a liberal policy of extending trade credit, or (ii) better/poor quality of
receivables. A liberal trade credit policy may be aimed at augmenting sales.
Second, it may be more appropriately examined in relation to the credit terms and policy of the firm itself. In
our example, the average collection period is 45 days or 1.5 months. This should be compared with the
credit terms/period normally allowed by the firm. If the normal credit period, let us assume, as extended by
the firm is 40-45 days, it means the firm can collect its receivables well within the due dates. If, however, the
credit period normally allowed is 1 month or 30 days, it means that the debtors are outstanding for a period
longer than warranted by the firm’s credit policy. This may be a reflection on the efficiency of the credit
collection department: it has made either poor credit selection or inadequate collection effort. The
management should investigate the reasons for the difficulties in the collection of receivables.

3. Creditors Turnover Ratio – It is a ratio between net credit purchases and the average amount of creditors
outstanding during the year.
Creditor turnover = Net Credit purchases
Average creditors + Average bills payable (B/P)
• Net credit purchases = Gross credit purchases less returns to suppliers
• Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at
the end of the year
 Based on accounts payable, we can generate a days payable, which indicates the average number of days
the company takes to pay suppliers.
A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts
are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its
requirement of current assets by relying on supplier’s credit. The extent to which trade creditors are willing
to wait for payment can be approximated by the creditor’s turnover ratio.
Companies having large amount of payables mean that it is in trouble or that it is granted credit easily
by suppliers because of its size. If the company has large amount of cash, it’s not in financial trouble.
So, it’s a company with a strong position in the marketplace and power over its suppliers.

4. Assets Turnover Ratio – This ratio is also known as the investment turnover ratio. It is based on the
relationship between the revenue and assets/investments of a firm. A reference to this was made while
working out the overall profitability of a firm as reflected in its earning power. Depending upon the different
concepts of assets employed, there are many variants of this ratio.

Total assets turnover = Revenue

Average total assets

Fixed assets turnover = Revenue

Average fixed assets

Here, the total assets and fixed assets are net of depreciation and the assets are exclusive of fictitious assets
like debit balance of profit and loss account and deferred expenditures and so on.
The assets turnover ratio measures how effectively a company is using its assets to generate revenue. It is a
critical measure of a company’s productivity. The higher the turnover ratio, the more efficient is the
management and utilisation of the assets while low turnover ratios are indicative of underutilisation of
available resources and presence of idle capacity. In operational terms, it implies that the firm can expand its
activity level (in terms of production and sales) without requiring additional capital investments. In the case
of high ratios, the firm would normally be required, other things being equal, to make additional capital
investments to operate at higher level of activity. To determine the efficiency of the ratio, it should be
compared across time as well as with the industry average.
Example, a grocery store doesn’t make money on every box of cereal sold. Food retailers are the highest on
asset turnover because the whole game is turning over those inventories as quickly as possible. That’s why
asset turnover is the most important factor in achieving ROE for food retailers.
Since assets/fixed assets are net of depreciation, the ratio is likely to be higher in the case of an old and
established company as compared to a new one, other things being equal. The turnover ratio is in such cases
likely to give a misleading impression regarding the relative efficiency with which assets are being used.

Q. What are Leverage/Capital Structure Ratios?

Leverage corresponds roughly to financing choices and capital structure. Just as lever lets you move a rock you
couldn’t otherwise move, leverage in finance allows owners to control assets they couldn’t control otherwise.
Leverage refers to the strategic use of borrowed capital, such as loans or debt, to increase the potential return on an
investment or to amplify the impact of a financial transaction. It involves using a relatively small amount of your own
money (equity) to control a larger amount of assets or investments.
Managing leverage is critical because it magnifies your returns – in both directions. Leverage multiplies both gains
and losses, adding to overall risk. On the positive side, this multiplication can increase profits; in times of negative
profitability, however, leverage increases the magnitude of losses. Banks have the highest amount of leverage. The
long-term lenders/creditors would judge the soundness of a firm based on the long-term financial strength
measured in terms of its ability to pay the interest regularly as well as repay the instalment of the principal on due
dates or in one lump sum at the time of maturity. The long-term solvency of a firm can be examined by using
leverage or capital structure ratios.

The leverage or capital structure ratios may be defined as financial ratios which throw light on the long-term
solvency of a firm as reflected in its ability to assure the long-term lenders regarding (i) periodic payment of interest
during the period of the loan and (ii) repayment of principal on maturity or in predetermined instalments at due
dates.

Q. What are the different types of leverage ratios?

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of
debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category is
important because companies rely on a mixture of equity and debt to finance their operations, and knowing the
amount of debt held by a company is useful in evaluating whether it can pay off its debts as they come due. There
are two different, but mutually dependent and interrelated, types of leverage ratios.

● Ratios that are based on the relationship between borrowed funds and owner’s capital. These ratios are
computed from the balance sheet and have many variations such as (a) debt-equity ratio, (b) debt-assets
ratio, (c) equity-assets ratio, and so on.
● Coverage ratios are calculated from the profit and loss account. Included in this category are (a) interest
coverage ratio, (b) dividend coverage ratio, (c) total fixed charges coverage ratio, (d) cash flow coverage
ratio, and (e) debt services coverage ratio.

1. Debt-Equity Ratios - The relationship between borrowed funds and owner’s capital is a popular measure of
the long-term financial solvency of a firm. This relationship is shown by the debt-equity ratios. This ratio
reflects the relative claims of creditors and shareholders against the assets of the firm. Alternatively, this
ratio indicates the relative proportions of debt and equity in financing the assets of a firm.

The debt considered here is inclusive of current liabilities.

shareholders’ equity = includes (i) equity and preference share capital (Preferred stock is often called a
hybrid instrument because it combines elements of both debt and equity claims. It is issued by companies
that have hit hard times and faces a risky future. Issuing preferred stock indicates a company’s troubled
financial position. VCs which provide funding for entrepreneurial ventures, almost always receive preferred
stock in exchange for their funding because it allows them to protect their investment in the event that the
company does poorly, while still participating in the upside if the company does well by converting their
preferred stock into common stock when things go well), (ii) past accumulated profits but excludes fictitious
assets like past accumulated losses (retained earnings are a part of shareholders’ equity because it is as if the
owners received a dividend and reinvested it in the company – just as they did when they originally invested
in the company), (iii) discount on issue of shares and so on.

The D/E ratio is, thus, the ratio of total outside liabilities to owners’ total funds. In other words, it is the ratio
of the amount invested by outsiders to the amount invested by the owners of business.

Current liabilities should be included in the total outside liabilities to calculate the D/E ratio because:

● Individual items of current liabilities are certainly short-term and may fluctuate widely, but, as a
whole, a fixed amount of them is always in use so that they are available more or less on a long-term
footing.
● Some current liabilities like bank credit, which are ostensibly short-term, are renewed year after year
and remain by and large permanently in the business.
 ● Current liabilities have, like the long-term creditors, a prior right on the assets of the business and
are paid along with long-term lenders at the time of liquidation of the firm.
● The short-term creditors exercise as much, if not more, pressure on management. The omission of
current liabilities in calculating the D/E ratio would lead to misleading results.

Should preference share capital be included in the debt or equity?

The exact treatment will depend upon the purpose for which the D/E ratio is being computed.

● If the object is to examine the financial solvency of a firm in terms of its ability to avoid financial risk,
preference capital should be clubbed with equity capital.
● If, however, the D/E ratio is calculated to show the effect of the use of fixed-interest/dividend
sources of funds on the earnings available to the ordinary shareholders, preference capital should be
clubbed with debt.

Interpretation of debt-equity ratio: The ratio reflects the relative contribution of creditors and owners of
business in its financing. A high ratio shows a large share of financing by the creditors of the firm; a low ratio
implies a smaller claim of creditors. The D/E ratio indicates the margin of safety to the creditors. If, for
instance, the D/E ratio is 1 : 2, it implies that for every rupee of outside liability, the firm has two rupees of
owner’s capital or the stake of the creditors is one-half of the owners. There is, therefore, a safety margin of
66.67 per cent available to the creditors of the firm. The firm would be able to meet the creditors’ claims
even if the value of the assets declines by 66.67 per cent. Conversely, if the D/E ratio is 2 : 1, it implies low
safety margin (one-third) for the creditors.

High debt-equity ratio:

● Implications for creditors - If the D/E ratio is high, the owners are putting up relatively less money of
their own. It is a dangerous signal for creditors. If the project should fail financially, the creditors
would lose heavily. Moreover, with a small financial stake in the firm, the owners may behave
irresponsibly and indulge in speculative activity. If they are heavily involved financially, they will
strain every nerve to make the enterprise a success. In brief, the greater the D/E ratio, the greater
the risk to the creditors.
● Implications for the firm - A high proportion of debt in the capital structure would lead to inflexibility
in the operations of the firm as creditors would exercise pressure and interfere in management.
Secondly, such a firm would be able to borrow only under very restrictive terms and conditions.
Further, it would have to face a heavy burden of interest payments, particularly in adverse
circumstances when profits decline. Finally, the firm will have to encounter serious difficulties in
raising funds in the future.

Low debt-equity ratio:

● Implications for creditors - To the creditors, a relatively high stake of the owners implies sufficient
safety margin and substantial protection against shrinkage in assets.
● Implications for the firm - For the company also, the servicing of debt is less burdensome and
consequently its credit standing is not adversely affected, its operational flexibility is not jeopardized
and it will be able to raise additional funds.

Ideal debt-equity ratio: The general proposition is: other’s money should be in reasonable proportion to the
owner’s capital and the owners should have sufficient stake in the fortunes of the enterprise.
For example, firms having a stable income such as an electricity company, can afford to have a higher D/E
ratio. Similarly, capital intensive industries and firms producing a basic product, like cement, tend to use a
larger proportion of debt. The tolerable D/E ratio of a new company would be much lower than for an
established one.
2. Debt to Total Capital Ratio - The relationship between creditors’ funds and owner’s capital can also be
expressed in terms of another leverage ratio. This is the debt to total capital ratio. Here, the outside
liabilities are related to the total capitalisation of the firm and not merely to the shareholder’s equity.
The approach is to relate the long-term debt to the permanent capital of the firm. Included in the permanent
capital are shareholders’ equity as well as long-term debt.
Debt to Capitalisation = Long-term Debt
Debt + Shareholders’ equity
It indicates what proportion of the permanent capital of a firm consists of long-term debt and therefore
diverts attention from liabilities that are part of operations. If the ratio for a firm is 1:2, it implies that one-
third of the total permanent capital of the firm is in the form of long-term debts. Although no hard and fast
rules exist, conventionally a ratio of 1:2 is satisfactory.

3. Debt to total assets (capital ratio) - Another approach to calculating the debt to capital ratio is to relate the
total debt to the total assets of the firm. The total debt of the firm comprises long-term debt plus current
liabilities. The total assets consist of permanent capital plus current liabilities.
Debt to Assets = Total debt
Total assets
It measures the share of the total assets financed by debt (outside funds). It provides a balance sheet
perspective on leverage.
A low ratio of debt to total assets is desirable from the point of the creditors/ lenders as there is sufficient
margin of safety available to them. But its implications for the shareholders are that debt is not being
exploited to make available to them the benefit of trading on equity. A firm with a very high ratio would
expose the creditors to higher risk.

4. Proprietary ratio - another variant of the D/E ratio is to relates the owner’s/proprietor’s funds with total
assets. This is called the proprietary ratio. The ratio indicates the proportion of total assets financed by
owners.
It shows what portion of the total assets are financed by the owner’s capital.
The implications of the ratio of equity capital of total assets are exactly opposite to that of the debt to total
assets. A firm should have neither a very high ratio nor a very low ratio.

5. Capital gearing ratio - the relationship between equity funds (also referred to as net worth) and fixed-income
bearing funds (preference shares, debentures, and other borrowed funds). This ratio, called the capital
gearing ratio, is useful when the objective is to show the effect of the use of fixed-interest/dividend source
of funds on the earnings available to the equity shareholders.

6. Assets to Shareholders’ Equity (Financial Leverage) – This ratio tells us precisely how many more assets an
owner can control relative to their own equity capital. Consequently, it also measures how returns are
magnified through the use of leverage.

Assets to Shareholders’ Equity = Assets

Shareholders’ equity

• Varying levels of leverage reflect the amount of business risk because it is unwise to pile financial
risk on top of business risk. Companies in stable, predictable industries with reliable cash flows are
more likely to have high leverage. Power and Light companies have stable demand, and their pricing
 is likely regulated, so their cash flows are steady. Accordingly, they can sustain higher amounts of
leverage. In contrast, a business that is very high risk, like Intel, shouldn’t carry large amounts of
leverage. Intel creates a new chip every 2 years that does twice as much in half as much space at half
the cost. And it builds new plants around the world that cost billions of dollars to build the next
generation of chips. If it gets one new version wrong, it can go out of business.
• With high business risk, there should be low financial risk. Because leverage increases risks, the
companies most likely to have high amounts of leverage are those whose business models expose
them to the least amount of risk. Companies in new industries are typically risky, so financial risk
would compound that business risk.

Coverage Ratios - These ratios are computed from information available in the profit and loss account. For a normal
firm, in the ordinary course of business, the claims of creditors are not met out of the sale proceeds of the
permanent assets of the firm. The obligations of a firm are normally met out of the earnings or operating profits.
These claims consist of (i) interest on loans, (ii) preference dividend, and (iii) amortization of principal or repayment
of the instalment of loans or redemption of preference capital on maturity.

The soundness of a firm, from the viewpoint of long-term creditors, lies in its ability to service its claims. This ability
is indicated by the coverage ratios. The coverage ratios measure the relationship between what is normally available
from the operations of the firms and the claims of the outsiders.

1. Interest Coverage Ratio - It is also known as ‘time-interest-earned ratio’. This ratio measures the company’s
ability to fund fixed interest payments on the long-term loans from its operations and uses only data from
the income statement. It is determined by dividing the operating profits or earnings before interest and
taxes (EBIT) by the fixed interest charges on loans.

ICR = EBIT
Interest

This ratio uses the concept of net profits before taxes because interest is tax-deductible so that tax is
calculated after paying interest on long-term loan.

A ratio of 1 indicates that a company is just able to make its interest payments with its current operations.

This ratio, as the name suggests, indicates the extent to which a fall in EBIT is tolerable in that the ability of
the firm to service its interest payments would not be adversely affected. For instance, an interest coverage
of 10 times would imply that even if the firm’s EBIT were to decline to one-tenth of the present level, the
operating profits available for servicing the interest on loan would still be equivalent to the claims of the
lenders. On the other hand, a coverage of five times would indicate that a fall in operating earnings only to
up to one-fifth level can be tolerated.

From the point of view of the lenders, the larger the coverage, the greater is the ability of the firm to handle
fixed-charge liabilities and the more assured is the payment of interest to them. However, too high a ratio
may imply unused debt capacity. In contrast, a low ratio is a danger signal that the firm is using excessive
debt and does not have the ability to offer assured payment of interest to the lenders.

A ratio less than 1 means that the company doesn’t have enough operating profit to pay its interest. This is a
near death situation for the company. It needs to raise more cash:
1. If inventory turnover increases markedly, while gross margins dip significantly, that pattern indicates
a fire sale of sorts. It liquidated goods as fast as it could to raise cash to make its interest payments
(If a company is moving more inventory and its gross margins are improving significantly, it indicates
that the company is selling inventory not by cutting prices, but it was getting pricing power and
raising prices just as it was moving more goods).
 2. If receivables collection period drops significantly, that didn’t happen accidentally. Another way to
raise cash is to contact the customers that owe money and ask them for, say, Rs. 0.80 on the rupee.
In short, the company needed the cash and was willing to make deals because it needed to raise
cash to make interest payments.
3. If the company pays its suppliers more quickly, which may seem odd for a company that’s strapped
for cash. But the shrinking payables period is more likely directed by its suppliers, who, given the
company’s financial situation, are unlikely to extend credit. Instead, they may demand cash on
delivery.

2. Dividend Coverage Ratio –

● It measures the ability of a firm to pay dividend on preference shares which carry a stated rate of
return.
● This ratio is the ratio (expressed as x number of times) of net profits after taxes (EAT) and the
amount of preference dividend.
● Although preference dividend is a fixed obligation, the earnings taken into account are after taxes.
This is because, unlike debt on which interest is a charge on the profits of the firm, the preference
dividend is treated as an appropriation of profit.
● The ratio, like the interest coverage ratio, reveals the safety margin available to the preference
shareholders. As a rule, the higher the coverage, the better it is from their point of view.

3. Total Fixed Charge Coverage Ratio – While the interest coverage and preference dividend coverage ratios
consider the fixed obligations of a firm to the respective suppliers of funds, that is, creditors and preference
shareholders, the total coverage ratio has a wider scope and considers all the committed fixed obligations of
a firm, that is, (i) interest on loan, (ii) preference dividend, (iii) lease payments, and (iv) repayment of
principal.

4. Total Cashflow Coverage Ratio – The coverage ratios mentioned above, suffer from one major limitation,
that is, they relate the firm’s ability to meet its various financial obligations to its earnings.
But these payments are met out of cash available with the firm. Accordingly, it would be more appropriate
to relate cash resources of a firm to its various fixed financial obligations. The ratio, so determined, is
referred to as total cash flow coverage ratio.
The overall ability of a firm to service outside liabilities is truly reflected in the total cash flow coverage ratio:
the higher the coverage, the better is the ability.

Internally generated cash from operating activities (CFO) are required for investment as well as debt servicing. A
typical firm requires funds both for growth, apart from replacement of existing fixed assets (in particular, plant and
machinery) and servicing of debt. Accordingly, a firm’s long-term solvency is a function of its ability (i) to finance the
expansion and replacements needs of the business and (ii) to generate cash for servicing of debt.

5. Capital Expenditure Ratio – It measures the relationship between the firm’s ability to generate CFO and its
capital expenditure requirements.
It is determined dividing CFO by capital expenditure. The higher the ratio, the better it is.
The ratio greater than one indicates that the firm has cash to service debt as well as to make payment of
dividends.
 6. Debt-Service Coverage Ratio (DSCR) –
● It is considered a more comprehensive and apt measure to compute debt service capacity of a
business firm.
● It provides the value in terms of the number of times the total debt service obligations consisting of
interest and repayment of principal in instalments are covered by the total operating funds available
after the payment of taxes: Earnings after taxes, EAT + Interest + Depreciation + Other non-cash
expenditures like amortisation (OA).
● The higher the ratio, the better it is.
● A ratio of less than one may be taken as a sign of long-term solvency problem as it indicates that the
firm does not generate enough cash internally to service debt.
● In general, lending financial institutions consider 2:1 as a satisfactory ratio.

Q. What are Profitability Ratios?

Apart from the creditors, both short-term and long-term, also interested in the financial soundness of a firm are the
owners and management or the company itself. The management of the firm is naturally eager to measure its
operating efficiency. Similarly, the owners invest their funds in the expectation of reasonable returns.

The operating efficiency of a firm and its ability to ensure adequate returns to its shareholders/owners depends
ultimately on the profits earned by it. The profitability of a firm can be measured by its profitability ratios. In other
words, the profitability ratios are designed to provide answers to questions such as:

i. is the profit earned by the firm adequate?

ii. what rate of return does it represent?
iii. what is the rate of profit for various divisions and segments of the firm?
iv. what are the earnings per share?
v. what was the amount paid in dividends?
vi. what is the rate of return to equity-holders?

Q. What are the different types of profitability ratios?

Profitability ratios can be determined on the basis of either sales or investments.

Profitability ratios related to sales – These ratios are based on the premise that a firm should earn
sufficient profit on each rupee of sales. If adequate profits are not earned on sales, there will be
difficulty in meeting the operating expenses and no returns will be available to the owners.

1. Profit margin (gross and net) – The profit margin measures the relationship between profit and sales. As
the profits may be gross or net, there are two types of profit margins: Gross profit margin and Net profit
margin. It asks the question: For every dollar of revenue, how much money does a firm get to keep after
all relevant costs?

(i) Gross Profit Margin – It is also known as gross margin. It measures the percentage of each sales
rupee remaining after the firm has paid for its goods.

Gross profit margin = Gross profit X 100

Sales

If the sales of a firm amount to Rs 40,00,000 and its gross profit is Rs 10,00,000, the gross margin
would be 25 per cent (Rs 10,00,000 Rs 40,00,000). If the gross margin (25 per cent) is deducted
 from 100, the result (75 per cent) is the ratio of cost of goods sold to sales. The former measures
profits in relation to sales, while the latter reveals the relationship between cost of production
and sale price.
Gross profit is the result of the relationship between prices, sales volume, and costs. A change in
the gross margin can be brought about by changes in any of these factors.
● High ratio – A high ratio of gross profit to sales is a sign of good management as it
implies that the cost of production of the firm is relatively low. It may also be indicative
of a higher sales price without a corresponding increase in the cost of goods sold. It is
also likely that cost of sales might have declined without a corresponding decline in sales
price. Nevertheless, a very high and rising gross margin may also be the result of
unsatisfactory basis of valuation of stock, that is, overvaluation of closing stock and/or
undervaluation of opening stock.
● Low ratio – A relatively low gross margin is definitely a danger signal, warranting a
careful and detailed analysis of the factors responsible for it. The important contributory
factors may be (i) a high cost of production reflecting acquisition of raw materials and
other inputs on unfavourable terms, inefficient utilisation of current as well as fixed
assets, and so on; and (ii) a low selling price resulting from severe competition, inferior
quality of the product, lack of demand, and so on.
● A firm should have a reasonable gross margin to ensure adequate coverage for
operating expenses of the firm and sufficient return to the owners of the business,
which is reflected in the net profit margin.

(ii) Net Profit Margin – It is also known as net margin. This measures the relationship between net
profits and sales of a firm. It measures the percentage of each sales rupee remaining after all
costs and expenses including interest and taxes have been deducted.
Gross profit only subtracts the expenses related to the production of goods from revenue, while
operating profit also subtracts other operating costs, such as selling and administrative costs.
Finally, net profit also subtracts interest and tax expenses from operating profit.

Example, bookstores are losing money because they are disappearing worldwide; bookselling is
a very tough business given the rise of Amazon, and this shows up as a negative profit margin.
Commodifying industry like Dell has a really low profit margin like over the past 10-15 years, the
laptop industry has become very commodified, which shows up as depressed profitability; that
kind of commodification hasn’t happened in software or in pharmaceuticals.

Profitability measures a company’s value addition and varies with the amount of that value
addition. Food retailers just don’t add much value, so even the very best food retailers get
margins of only 4%. In contrast, Intel takes sand and makes it into computers. That’s real value
added. So, profitability is going to reflect that underlying process of value addition.

Depending on the concept of net profit employed, this ratio can be computed in three ways:

1. Operating profit ratio = Earnings before interest and taxes (EBIT)

Net sales

2. Pre-tax profit ratio = Earnings before taxes (EBT)

Net sales

3. Net profit ratio = Net Profit

Net sales
 The net profit margin is indicative of management’s ability to operate the business with
sufficient success not only to recover from revenues of the period, the cost of merchandise or
services, the expenses of operating the business (including depreciation) and the cost of the
borrowed funds, but also to leave a margin of reasonable compensation to the owners for
providing their capital at risk. The ratio of net profit (after interest and taxes) to sales essentially
expresses the cost price effectiveness of the operation.
● High ratio – A high net profit margin would ensure adequate return to the owners as
well as enable a firm to withstand adverse economic conditions when selling price is
declining, cost of production is rising and demand for the product is falling.
● Low ratio – A low net profit margin has the opposite implications. However, a firm with a
low profit margin, can earn a high rate of return on investments if it has a higher
inventory turnover.

Limitations of Net Profit:

• It treats cash and non-cash expenses symmetrically.
• It also subtracts interest payments, which makes it hard to compare companies that
finance themselves in different ways even though their operations could be quite
similar.
• Many managerial decisions are involved in calculating profit. For example, an upfront
payment for a piece of equipment has to be capitalised, placed on the balance sheet,
and then depreciated over time. But this process of smoothening measures of
performance is subjective, which allows managers to manipulate profits to their
advantage.

Conclusion –
(i) The profit margin should, therefore, be evaluated in relation to the turnover ratio. In other
words, the overall rate of return is the product of the net profit margin and the investment
turnover ratio.
(ii) Similarly, the gross profit margin and the net profit margin should be jointly evaluated. The need
for joint analysis arises because the two ratios may show different trends. For example, the
gross margin may show a substantial increase over a period of time but the net profit margin
may (i) have remained constant, or (ii) may not have increased as fast as the gross margin, or (iii)
may actually have declined. It may be due to the fact that the increase in the operating expenses
individually may behave abnormally. On the other hand, if either as a whole or individual items
of operating expenses decline substantially, a decrease in gross margin may be associated with
an improvement in the net profit margin.

2. EBITDA Margin – It’s an indication that we’re moving away from the accounting idea of profits and
toward the emphasis on cash in finance.
EBIT = operating profit = earnings before interest and taxes
Since some companies have different tax burdens and capital structures, EBIT provides a way to
compare their performances more directly.
• Depreciation refers to how physical assets, such as vehicles and equipment, lose value over time,
and amortisation refers to that same phenomenon but for intangible assets. In finance, we
emphasize cash and DA are expenses that are not associated with the outlay of cash; it is just an
approximation of the loss of value of an asset.
So, EBITDA is a measure of the cash generated by operations.
Example, a company having large EBITDA margin as compared to Net Profit margin means that it is
generating a large amount of depreciation and amortisation. That’s what utilities like an electric & gas
 utility company do. And often in the utility industry, people talk of EBITDA as opposed to profitability
because they know how distorting all that depreciation and amortisation can be.

Profitability Ratios Related to Investments – The profitability ratios can also be computed by relating the profits of a
firm to its investments. Such ratios are popularly termed as return on investments (ROI). There are three different
concepts of investments in vogue in financial literature: assets, capital employed and shareholders’ equity.

1. Return on Assets (ROA) – Here, the profitability ratio is measured in terms of the relationship between net
profits and assets. The ROA may also be called profit-to-asset ratio. It asks the question: How much profit
does a company generate for every dollar of assets? This means how effectively a company’s assets are
generating profits.
● The concept of net profit may be (i) net profits after taxes, (ii) net profits after taxes plus interest,
and (iii) net profits after taxes plus interest minus tax savings.
● Assets may be defined as (i) total assets, (ii) fixed assets, and (iii) tangible assets.
Property, plant, and equipment (PP&E) is the term for the tangible, long-term assets that a
company uses to produce or distribute its product. For example, its headquarters, factories,
machines in those factories, and stores. Brick-and-mortar retailer has higher PPE, whereas
an online marketplace retailer like Amazon would have lower PPE. In the grocery business,
managing the cold chain is really expensive, so grocery stores have more equipment and
considerably more PPE than a retail drug chain. An electric and gas utility company has
power plants, and therefore very significant PPE. Companies like Dell, Microsoft, and Pfizer
don’t really do any heavy manufacturing so they have low levels of PPE.
Intangible assets like patents, brands, and goodwill (when a company acquires another
company for more than the value of its assets on the balance sheet, that difference is
recorded on the acquiring company’s balance sheet as goodwill) are included in Other
Assets. So, companies with lots of other assets and goodwill are likely those that have
bought other companies with many intangible assets.
Accordingly, the different variants of the RAO are:
Return on assets (ROA) = (Net profit after taxes + Interest – Tax advantage on interest) X 100
Average total assets/Tangible assets/Fixed assets

Typically, an improvement in asset performance means that a company can either earn a higher return using
the same amount of assets or is efficient enough to create the same amount of return using fewer assets.
Investors expect that good management will strive to increase the ROA—to extract a greater profit from
every dollar of assets at its disposal.
The real return on the total assets is the net earnings available to owners (EAT) and interest to lenders as
assets are financed by owners as well as creditors. A more reliable indicator of the true return on assets,
therefore, is the net profits inclusive of interest. It reports the total return accruing to all providers of capital
(debt and equity).
Also, firms have markedly varying capital structures as interest payment on debt qualifies for tax deduction
in determining net taxable income. Therefore, the effective cash outflow is less than the actual payment of
interest by the amount of tax shield on interest payment.
This equation correctly reports the operating efficiency of firms as if they are all equity financed.
The ROA measures the profitability of the total funds/ investments of a firm. It, however, throws no light on
the profitability of the different sources of funds which finance the total assets. These aspects are covered
by other ROIs.
A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales
growth often means major upfront investments in assets, including accounts receivables, inventories,
 production equipment, and facilities. A decline in demand can leave an organization high and dry and over-
invested in assets it cannot sell to pay its bills. The result can be a financial disaster.

2. Return on Capital Employed (ROCE) – The ROCE is the second type of ROI. It’s also known as return on
invested capital. It is like the ROA except in one respect. Here the profits are related to the total capital
employed. It is a particularly important measure as it considers both capital providers and their combined
return. The combined return to capital providers is all operating income (or EBIT) after taxes, also known as
EBIAT.
The term capital employed refers to long-term funds supplied by the lenders and owners of the firm. It can
be computed in two ways.
● First, it is equal to non-current liabilities (long-term liabilities) plus owners’ equity. Alternatively, it is
equivalent to net working capital plus fixed assets.
● Second, it is equal to long-term funds minus investments made outside the firm.

ROCE = EBIAT
Debt + Equity

Thus, the capital employed basis provides a test of profitability related to the sources of long-term funds.
A comparison of this ratio with similar firms, with the industry average and over time would provide
sufficient insight into how efficiently the long-term funds of owners and lenders are being used. The higher
the ratio, the more efficient is the use of capital employed.
ROCE = (Net profit after taxes + Interest – Tax advantage on interest) X 100
Average total capital employed

3. Return on Shareholders’ Equity (ROE) – This profitability ratio carries the relationship of return to the
sources of funds yet another step further.
While the ROCE expresses the profitability of a firm in relation to the funds supplied by the lenders and
owners taken together, the return on shareholders’ equity measures the annual return that shareholders
earn.
The shareholders of a firm fall into two broad groups: preference shareholders and equity shareholders. The
holders of preference shares enjoy a preference over equity shareholders in respect of receiving dividends.
In other words, from the net profits available to the shareholders, the preference dividend is paid first and
whatever remains belongs to the ordinary shareholders.
The profitability ratios based on shareholders’ equity are termed as return on shareholders’ equity. It asks
the question: For every dollar of equity that shareholders invest in a company, how much do they get back
every year?

(i) Return on Total Shareholders’ Equity – The term shareholders’ equity includes (i) preference share
capital; (ii) ordinary shareholders’ equity consisting of (a) equity share capital, (b) share premium,
and (c) reserves and surplus less accumulated losses. The ordinary shareholders’ equity is also
referred to as net worth.
The ratio reveals how profitably the owners’ funds have been utilised by the firm. A comparison of
this ratio with that of similar firms as also with the industry average will throw light on the relative
performance and strength of the firm.

Return on total shareholders' equity = Net profit after taxes (but before preference dividend) X 100
Average total shareholders’ equity
(ii) Return on Ordinary Shareholders’ Equity (Net Worth) – While there is no doubt that the preference
shareholders are also owners of a firm, the real owners are the ordinary shareholders who bear all
the risk, participate in management, and are entitled to all the profits remaining after all outside
claims including preference dividends are met in full. The profitability of a firm from the owners’
point of view should, therefore, in the fitness of things be assessed in terms of the return to the
ordinary shareholders. The ratio under reference serves this purpose. It is calculated by dividing the
profits after taxes and preference dividend by the average equity of the ordinary shareholders.

Return on equity funds = (Net profit after taxes – Preference dividend) X 100
Average ordinary shareholders’ equity

This is probably the single most important ratio to judge whether the firm has earned a satisfactory
return for its equity-holders or not. Its adequacy can be judged by (i) comparing it with the past
record of the same firm, (ii) inter-firm comparison, and (iii) comparisons with the overall industry
average. The rate of return on ordinary shareholders’ equity is of crucial significance in ratio analysis
vis-a-vis from the point of the owners of the firm.

(iii) Earnings Per Share (EPS) – It measures the profit available to the equity shareholders on a per share
basis, that is, the amount that they can get on every share held. The profits available to the ordinary
shareholders are represented by.

EPS = Net profit available to equity holders (net profits after taxes and preference dividend)
Number of ordinary shares outstanding

As a profitability ratio, the EPS can be used to draw inferences based on (i) its trends over a period of
time, (ii) comparison with the EPS of other firms, and (iii) comparison with the industry average.

Limitations of EPS:
● EPS as a measure of profitability of a firm from the owner’s point of view, should be used
cautiously as it does not recognise the effect of increase in equity capital as a result of
retention of earnings. In other words, if EPS has increased over the years, it does not
necessarily follow that the firm’s profitability has improved because the increased profits to
the owners may be the effect of an enlarged equity capital as a result of profit retentions,
though the number of ordinary shares outstanding remains constant.
● It does not reveal how much is paid to the owners as dividend, nor how much of the
earnings are retained in the business. It only shows how much earnings theoretically belong
to the ordinary shareholders (per share basis).

(iv) Cash Earnings Per Share – It is computed using cash flows from business operations as the
numerator. This value is determined by adding non-cash expenses, such as depreciation and
amortisation to net profits available to equity owners. Thus,
Cash EPS = Net profit available to equity owners + Depreciation + Amortisation + non-cash expenses
Number of equity shares outstanding
The ratio indicates the cash generating ability (per equity share) of the firm. Like EPS, cash EPS
should be used with caution. It is beset with all the limitations associated with EPS measure.

(v) Book Value Per Share – It represents the equity/claim of the equity shareholder on a per share basis.
Book value per share = Net worth (equity share capital + reserves and surplus – accumulated losses)
Number of equity shares outstanding (at balance sheet date)
 This ratio is sometimes used as a benchmark for comparisons with the market price per share.
However, the book value per share has a serious limitation as a valuation tool as it is based on the
historical costs of the assets of a firm. There may be a significant difference between the market
value of assets from the book value of assets (as per balance sheet). Besides, there may be hidden
assets or other intangible assets of uncertain value.

(vi) Price-to-Book Value Ratio – Also known as price to book (P/B) ratio, measures the relationship
between the market price of an equity share (MPS) with book value per share (BPS).
P/B ratio = MPS
BPS
The P/B ratio is significant in predicting future stock returns. For instance, Fama and French
observed that the P/B ratio (along with size) was the best predictor of future stock returns. Firms
with low P/B ratios had consistently higher returns compared to the firms with high P/B ratios.

(vii) Dividend Per Share (DPS) – It is the dividends paid to the equity shareholders on a per share basis. In
other words, DPS is the net distributed profit belonging to the ordinary shareholders divided by the
number of ordinary shares outstanding.
DPS = Dividend paid to ordinary shareholders
Number of ordinary shares outstanding
The DPS would be a better indicator than EPS as the former shows what exactly is received by the
owners. Like the EPS, the DPS also should not be taken at its face value as the increased DPS may not
be a reliable measure of profitability as the equity base may have increased due to increased
retention without any change in the number of outstanding shares.

(viii) Dividend Pay-out (D/P) Ratio – It is also known as pay-out ratio. It measures the relationship
between the earnings belonging to the ordinary shareholders and the dividend paid to them. In
other words, the D/P ratio shows what percentage share of the net profits after taxes and
preference dividend is paid out as dividend to the equity-holders.

D/P ratio = Total dividend (cash dividend) to equity holders X 100

Total net profit belonging to equity holders

D/P ratio = Dividend per ordinary share (DPS) X 100

Earnings per share (EPS)

If the D/P ratio is subtracted from 100, retention ratio is obtained. The ratio indicates what
percentage share of the net profits are retained in the business. To illustrate, if the net earnings
after taxes and preference dividends are Rs 5,00,000 and the dividend paid to the ordinary share-
holders amount to Rs 3,00,000, the D/P = 60 per cent. This implies that 40 per cent of the profits of
the firm are retained (retention ratio) and 60 per cent distributed as dividends. Similarly, if the DPS is
Rs 2 and EPS Rs 5, the D/P is 60 per cent. While 60 per cent profits are used to pay dividends, 40 per
cent are ploughed back.
The D/P ratio is an important and widely-used ratio. The pay-out ratio can be compared with the
trend over the years or an inter-firm and intra-industry comparison would throw light on its
adequacy.

(ix) Earnings and Dividend Yield – It is closely related to the EPS and DPS. While the EPS and DPS are
based on the book value per share, the yield is expressed in terms of the market value per share.
The earnings yield may be defined as the ratio of earnings per share to the market value per ordinary
share. The earnings yield is also called the earning-price ratio.
 Earnings yield = Earnings per share (EPS) X 100
Market value per share (MPS)

Similarly, the dividend yield is computed by dividing the cash dividends per share by the market
value per share.

Dividend yield = Dividend per share (DPS) X 100

Market value per share (MPS)

(x) Price Earnings (P/E) Ratio – It is closely related to the earnings yield/earnings price ratio. It is the
reciprocal of the latter.
P/E ratio = Market price of share
EPS
The P/E ratio reflects the price currently being paid by the market for each rupee of currently
reported EPS. In other words, the P/E ratio measures investors’ expectations, and the market
appraisal of the performance of a firm. In estimating the earnings, therefore, only normally
sustainable earnings associated with the assets are considered. That is, the earnings are adjusted for
income from, say, discontinued operations and extraordinary items as well as many other items not
expected to occur. This ratio is popularly used by security analysts to assess a firm’s performance as
expected by the investors.

The Most Important Ratio – Many financial analysts focus on Return on Equity (ROE) since it measures the returns to
owners, who are arguably the ultimate bosses within a company. The DuPont framework provides a useful way to
understand the levers of ROE.

Return on Equity (ROE) = Profitability X Productivity X Leverage

Profit Asset Leverage
Margin turnover

= Net profit X Revenue X Assets

Revenue Assets shareholders’ equity

The DuPont framework breaks ROE algebraically into 3 ingredients:

1. Profitability: How profitable a company is, i.e., for every dollar of revenue, how much dos it earn in net
profit?
2. Productivity: Being profitable is important, but an ROE can be bolstered by productivity as well. To measure
a company’s productivity, we use the asset turnover ratios, which measures how efficiently a company can
use its assets to generate sales.
3. Leverage: Leverage can magnify returns. It’s also an important contributor to ROE.

Like all other measurements, ROE is imperfect, and 2 problems stand out:
1. Because it includes the effects of leverage, it does not purely measure operational performance. That’s why
some people prefer a return on capital, which compares EBIT to a firm’s capitalization (debt plus equity).
2. It does not correspond to the cash-generating capability of a business.
Among the 4 pieces of DuPont framework i.e., ROE, profitability, productivity, and leverage, ROE is going to be the
most similar across 10 very different companies. While the companies don’t compete in product markets, they all
compete in capital markets. Consequently, the rewards to shareholders can’t deviate too far from each other
because capital will be driven away from low performers and toward better performers. That’s why ROEs look most
similar. But not all ROEs look the same because of the relationship between risk and return. If shareholders bear
more risk, they’re going to demand a higher return. So capital markets and the competition across companies drive
returns to shareholders together and risk drives them apart.

Limitations: While a high ROE is desirable, it is not always a good thing – the elements that make up that ROE can
help to determine whether that ROE is sustainable or built on a foundation that will destroy that company. A
company may underperform in profitability and productivity, but still manage to maintain the industry average
through leverage. Since its ROE comes from leverage, that means it’s overcoming poor operational performance by
making its owners bear more risk. This is one of the major problems with ROE. As valuable as it is, leverage has a way
of infecting the final calculation. That’s why some people turn to slightly different measures, like ROA and ROCE.
These measures take out the confounding influences of leverage and show that managers at the company deploy
capital less efficiently than their peers.

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Why cash is a better measure of economic returns relative to profits

Net Profit
EBITDA (free of noncash + interest
charges like depreciation & + taxes
+ depreciation & amortisation
amortisation) EBITDA

Net Profit
+ depreciation & amortisation
Operating Cash Flows - increases in accounts receivable
(accounts for changes in - increases in inventory
+ increases in unearned revenue
working capital) + increases in accounts payable
Operating cash flow

EBIT – taxes = EBIAT

Free Cash Flows (acknowledges + depreciation & amortisation
that capital expenditures are + changes in working capital
- capital expenditures
required for growth) Free cash flow

The operations of a business generate EBIT, but the government takes its share to make it EBIAT. From there, you
must consider the comoany’s ongoing invetsments into working capital and fixed assets as it grows. Finally, noncash
expenses such as depreciation and amortsiation should never have been expensed and must be added back. What’s
left is free cash flows, which are flows that assets generate that are truly free and truly cash.
Finance has slowly been moving toward free cash flow for evaluating returns because it captures all the cash
consequnces of a business, and it ensures that the underlying flows are free to the capital providers after accounting
for costs and expenses. Free cash flows can be deployed for new investments, or they can be distributed to capital
providers.
The emphasis on cash explains why companies that genearte profits but no cash might be unsustainable and why
companis that genearte no profits but lots of cash might be valuable.
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Equity reaserch Analyst – who value companies by creating forecasts and then make recommendations to investors.
They talk to various people like:
The companies: CEOs and CFOs about new product launches, startegy, and forecasts. Informations beyond raw
numbers to know how a company is performing, which is a crritical ingrienent for formulating forecatss that will
guide recommendations.
Institutional investors (the buy side/ money managers/ asset managers): entities that invest large amounts of capital
on behalf of others and allocate it in ways that they feel will best support their clients. Different kinds of funds –
mutual funds, pension funds, foundations and endowment funds, sovereign wealth funds, and hedge funds.
Mutual funds: they manage money on behalf of individuals and invest those funds in diversiifed portfolios of stocks
or bonds.
Investment banks (the sell side): traders, salespeople, investment banks

Efficient market thoery: it suggests that if information sis widely available to investors, then its impossible to
outperform the market because prices already reflect that available information. So trying to beat or time the
market over the long term is a useless endeavour. Passive funds are a manifestation of this throery.

Q. What does private equity do?

Ans. It buys compoanies, improves them, and then sells them to another private investor or the public markets

Ways in which companies finance their projects:

1. Equity – it is the most expensive source of financing. For example, an investor may balk at a company using
equity. If the project is so great, why issue new shares? The questions become: why are the owners, if
they’re so confident about the future, willing to share the upside? Why wouldn’t they keep the upside for
themselves by issuing debt? This is the reason equity issuance is usually associated with stock price declines.
Its not because of dilution or an accounting argument. Its because the stock issue sends a negative signal.
2. Debt – it seems a little better. Although a company is still relying on external capital providers, at least it’s
not giving up ownership. But whenever a company goes for outside source of funding, investors will always
ask why.
3. Internally generated profits – it’s the bests source of financing. There’s no informational cost associated with
it, but it can be a limited source.

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Sources of value creation

Value creation hinges on the idea of costly capital.

Returns demanded by capital providers (equity and debt holders) becomes the cost of capital for managers, and will
be a function of the risk these providers of capital bear.

Market-to-book ratio = compares a company’s book value and its market value
Book value = an accounting of the capital that shareholders have invested in a company
Market value = it measures how much a company is worth according to the financial markets. It is a forward-looking
assessment of the value of a company

Value creation is beating the cost of capital. The simple comparison – expected returns on an investment (ROE)
versus the cost of capital (discount rate) – is all you need to know to think through whether or not a company is
creating value.
• If equity is earning 20% and shareholders are only discounting future cash flows by 15% =
market-to-book ratio > 1
• If ROE drops to 15% and everything else stays same = market-to-book ratio = 1 (no value
creation)
• If ROE drops to 10% = market-to-book ratio < 1
If the ROE is the same as the cost of capital, nothing else matters – the company is not creating value. You could
have stayed in bed.
If the ROE is less than the cost of capital, it means that the company is not providing returns commensurate with the
capital providers’ expectations and as a consequence, is destroying value. The company is returning less to capital
providers than they demand given the risk they assumed.

Value creation also depends on ROE, the duration of the project, and the amount of profits reinvested in the
business.
Higher the reinvestment rate of earnings, higher is the value.
• Highest market-to-book ratio (high ROE, longest time) – High ROEs over a long-time span: that’s what makes
market-to-book ratios and value creation significant. The company would be earning its highest ROE, which
would lead to higher market values, and it would be doing it for the longest period of time.
• Smallest market-to-book ratio (low ROE, longest time) – The company’s ROE doesn’t beat its cost of capital
(its discount rate), but despite this, the company persists for 30 years, resulting in a great deal of value
destruction.
• Constant (exactly 1) market-to-book ratio (ROE = cost of capital) – No matter the time horizon, the market-
to-book ratio will always be 1. Since its ROE is the same as its cost of capital, its not going to create value, no
matter how long it operates, or what percentage of earnings it reinvests.

3 ways to create value:

1. Companies must beat their cost of capital. If they don’t, nothing else matters.
2. They must beat their cost of capital for many years
3. They must reinvest additional profits at high rates through growth

These prescriptions also correspond to business strategy. Beating a cost of capital is all about creating a competitive
advantage through innovation. Keeping the gap open between returns and costs of capital for longer periods is what
barriers to entry, brands, and intellectual property protection are all about. Finally, reinvesting more profits is all
about growing an opportunity through expansions, adjacencies, or integration.

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Cost of Capital

Cost of capital is critical to value creation. Managers apply discount rates to penalise future cash flows because there
is an opportunity cost to any investment. Those discount rates are often referred to as costs of capital because they
refer to the penalties (costs) associated with deploying that capital.

Where do those discount rates and costs of capital come from?

Firms have 2 types of capital providers – lenders who provide debt capital and owners who provide equity capital.
The costs of capital are a function of the returns that investors expect.
An investor’s expected return becomes the cost of capital for managers. The costs of debt and equity will be
different; equity is a residual claim with a variable return, whereas debt has a fixed return that has priority for
repayment.

Where do these expected returns (that become costs of capital) come from?
Providers of capital will measure the risk that they are exposed to and expect returns to compensate for that risk.
The demand for additional returns to bear risk is a foundational idea in finance and relates to risk aversion.

Weighted Average Cost of Capital (WACC) – it is the most common way to discount future cash flows. It implies 2
sources of capital that must be associated with 2 different costs: the cost of debt and the cost of equity. We can’t
simply add them but should average them to account for their relative proportions.
D E
WACC = ( ) rD (1 − t) + ( )r
D+E D+E E

rD = cost of debt
rE = cost of equity
D = market value of the firm’s debt
E = market value of the firm’s equity
D + E = total market value of the firm’s financing (equity and debt)
t = corporate tax rate

The costs of debt and equity are their expected returns.

Interest payments are typically deductible expenses that can lower a firm’s tax payments. In effect, these interest
payments shield a company from paying more taxes and are known as “tax shields”. How much benefit the interest
payments provide because of their deductibility depends on the tax rate. If tax rates are high, the ability to deduct
interest payments is very valuable. So, it actually costs less to pay interest, and reduces the true cost of interest.

In order to build your business, you use money. Who is lending or investing this money for you? We have
shareholders and banks or bondholders; you need to give a fair remuneration to all those people. And depending on
the structure of your capital, of your financing, then you have an average cost of capital, which is basically what it
costs you to be in business. No one would invest their own money to get an unreasonable return. It is very sound to
give those stakeholders a return that they are expecting.

Cost of debt – Cost of capital is the interest rate that a lender will charge.
To arrive at an interest rate, a bank will examine the riskiness of the underlying business, the stability of its cash
flows, and its credit rating. Then, it’ll charge an interest rate commensurate with that risk. (Technically, that interest
rate is the promised return and there is a probability that the issuer will default, meaning that the expected return is
slightly lower).
rD = 𝑟𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + credit spread
Risk-free rate – Investors will demand, at a minimum, the rate on a risk-free investment; risk-free investment is
approximated by the interest rate on govt securities.
At a minimum, any risky project should provide what we demand from a risk-free asset.

Why do investors charge a cost of capital in the absence of risk? We as investors don’t just dislike risk; we also like
things now rather than later, and we need compensation for delaying the enjoyment of our wealth. We prefer
money now rather than rather than later because we are impatient and we want to be compensated for any
expected inflation because that inflation will reduce our purchasing power.
Credit Spreads – It reflects the additional cost associated with the riskiness of the debt. Riskier companies feature
higher credit spreads.

Cost of debt comprise the risk-free rate plus a risk premium for credit risk. Rates are also influenced by the amount
of time until the bond will be paid, also known as the bond’s maturity date.
Longer-term debt typically needs to offer a higher interest rate than short-term bonds because future interest rates
are expected to be higher and longer-term bonds must compensate investors for fixing their interest rates for a
longer period. Future inters rates might be expected to be higher because of future growth or inflation
expectations.

Optimal capital structure – It’s the relative use of debt and equity in a company. The right capital structure varies by
industry and by the relative riskiness of those industries.
Regulated monopolies like power companies have capital structures heavily weighted toward debt because of their
steady cash flows; high-risk companies with unpredictable futures are weighted toward equity.

Q. What is the systematic and unsystematic risk?

● systematic risks are common to all, they are present in the system, and unsystematic risks are industry or
firm-specific.
● systematic risks include economic and political conditions like factors such as inflation rate, interest rates,
the effect of monsoon on agriculture production, change in govt policies on taxation, dividends, etc.
unsystematic risks include govt policies regarding a particular industry, labour, and raw material availability,
managerial competence of a firm, consumer preferences, etc.
● systematic risk cannot be eliminated through diversification. unsystematic risk can be diversified by the
creation of portfolios as the security-specific risks cancel each other partially, it falls rapidly as the size of the
portfolio increases, leaving only the systematic risk.

There is some volatility you can never fully diversify away; it is called systematic risk or the risk of holding the
market. So, every security’s risk is not measured by how much each stock moves around in general but rather by
how much each stock moves with the market, which represents the risk that will never be diversified away.

Q. Why do individuals hold a portfolio of assets/how to reduce risk?

A portfolio is diversified across the asset class like stocks, bonds, gold, govt securities, etc. in stocks, further
diversification can be done across industries. diversification is necessary to reduce the unsystematic risk by -

● the absolute amount invested in each stock is lower than if the entire amount was put into a single asset, so
the risk from each asset is limited.
● specific asset returns may be positive/negative in a particular period, and the average impact is likely to be
cancelled out in large portfolios.

Diversification provides a powerful way to manage risks because as you diversify, you can maintain expected returns
and reduce risk. If investors hold diversified portfolios, the volatility of any one given stock doesn’t matter that much
because much of that volatility gets washed away in the portfolio. As you add more securities to a portfolio, the
overall volatility of the portfolio decreases. But there is a level above which the gains from diversification diminish.

Beta
The beta is a measure of systematic risk. it shows how much risk the investment will add to a portfolio that looks like
the market. The measure of how a stock moves with the market is called a beta. If a market goes up or down, how
will the stock do?

If a company has a beta of 1, it generally moves in sync with the market; if the market goes up by 10%, then the
company’s stock is likely to go up by 10%. If a stock is riskier than the market, it will have a beta greater than one,
and provide the potential for higher returns. If a stock has a beta of less than one, the formula assumes it will reduce
the risk of a portfolio and yield lower returns.

Calculating betas

The beta of portfolio = sum (beta of individual stocks X proportion of funds in that stock). the beta of individual
stocks is calculated through covariance.

A beta measures the correlation between a given company’s returns and the market’s returns. If you simply draw a
line that best fits the data – also known as a regression – the slope of that line is going to capture what a beta is:
literally how the company co-moves with the market.

Some industries have betas that are relatively high – higher than 1.0 – which means that they move more than the
market. Typically, cyclical industries (like materials, automobiles & components, consumer durables & apparel,
technology hardware & equipment) look like this.

Intuition behind betas

The central intuition behind betas relates to insurance.

• High beta companies expose shareholders to larger amounts of systematic risk that they can’t diversify
away. Because of them, investors apply high discount rates, due to which present values become lower,
which leads to a high cost of equity. As a consequence, these firms have a higher WACC. And as a
consequence of that, their values will be lower.
• Negative beta companies have low costs of equity. They might even be negative, which means that their
WACC will be lower, which means their values will be higher. When the market goes up, this asset will
perform poorly. When the market does poorly, this asset will do really well. Negative beta assets are special
because when the world falls apart, they really deliver for you. As a consequence, you don’t demand much
of a return from them, and that leads to high values.

Q. explain CAPM (single index model/ market model)

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for
assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating
expected returns for assets given the risk of those assets and the cost of capital.

When we put together the ideas of the price of risk and the quantity of risk, we get an equation for the cost of
equity. The formula for calculating the expected return of an asset given its risk: E(R)=Rf+β(Rm-Rf)

rE = 𝑟𝑟𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + beta X market risk premium

where: E(R)=expected return of investment, β = beta of the investment (quantity of risk associated with a company),
(Rm−Rf) = market risk premium (price of risk).
If equities outperform safe risk-free instruments/securities by a fair margin on average, that must be the
compensation to investors for exposure to that risk of the market. In effect, that outperformance is the price of risk
– the compensation people demand for bearing equity risk – also known as the market risk premium.

1. At a minimum, investors will demand at least the risk-free rate or the amount that you charge when you
lend money to the govt.
2. There has to be some notion of a risk adjustment that will be composed of the combination of quantity of
risk and the price of risk. That gives you the expected return for a given industry or company, and as a
consequence, the cost of equity for those companies.

As betas increase, expected returns increase. Zero beta assets have an expected return equal to the risk-free rate.
Active investment management is all about pursuing assets that deviate from the line and deliver more than the
expected return. This gap is called alpha. It is the source of value creation, as isolating it means you’re delivering
greater-than-expected returns.

CAPM is based on several assumptions:

• No transaction costs
• Investors are able to borrow and lend at relatively low rates
• Investors are highly rational
• Realised returns always line up with betas

Much of CAPM is about insurance. You love the assets that move against the market because they provide you with
insurance. And, if you’re risk averse, that’s a valuable thing. Example, part of the attraction of investing in gold is that
when the world falls apart, the gold will be there for you, and that insurance is valuable and would lead you to ask
for low or negative returns.