Financial websites and Company
Results show various Returns and Ratio Figures, all calculated from different
particulars. Here in this Blog, we are giving you simple understanding of major
Return and Ratio used in Financial Market.
All the returns and ratios are easily
and freely available on many websites, you don’t have to calculate any of them;
this is for understanding on what they are actually showing.
Return, in its simplest term, mean
what you get against what you give. There are many Financial Returns that are
calculated in Stocks Market. All of them are calculated from Profit and Loss
account (What you get) and Balance Sheet (What you Give or What you put into work)
So Return = what you get / what you
give
i.e. a Profit and Loss Figure / a
Balance Sheet Figure
Here is an over simplified form of a
Profit & Loss Account and Balance Sheet. By the use of these figures,
returns understanding would be easier.
We know that the Reporting Proforma
has changed, but this is just for conception. I think it will be easier for
early investors to learn from direct examples;
BALANCE SHEET OF BWW
LIMITED:
LIABILITIES 
AMOUNT 
ASSETS 
AMOUNT 
Shareholders’
Equity 
Fixed Assets 

Share Capital 
125 
Property  Land 
300 
Reserves 
270 
Plants Machinery 
80 
395 
Long Term Investments 
55 

Long term Receivables 
30 

NonCurrent
liabilities 
465 

Debentures and Bonds 
120 

Long Term Loans 
95 
Current Assets 

215 
Inventory 
120 

Cash and Bank 
45 

Current
Liabilities 
Trade Receivables 
40 

Short Term Loans 
65 
Prepaid Expenses 
30 
Trade Payable 
20 
235 

Outstanding Expenses 
5 

90 

Total 
700 
Total 
700 
It tallied because its selfmade
excel sheet J
PROFIT AND LOSS
STATEMENT:
PARTICULARS 
AMOUNT 
Revenue from Operations
(exIndirect Taxes) 
755 
Other Income 
5 
Total Income 
760 
(Less): Cost of Goods sold 
450 
Gross
Profit 
310 
(Less): Other Indirect Expenses
(Salary etc) 
47 
EBITDA 
263 
(Less): Depreciation 
35 
EBIT 
228 
(Less): Interest 
30 
Profit
Before Tax 
198 
(Less): Tax @25% 
49.5 
Profit
After Tax 
148.5 
RETURN VS RATIO:
Too many investors get confused
between Return and Ratio. They both are calculated similarly, just presented
differently.
A ratio is presented in times; while
returns are presented in Percentage.
Another difference is that Ratios are
generally calculated from 2 Balance sheet items or 2 Profit and Loss items;
while returns are calculated from one Profit and Loss item and One Balance
Sheet item.
Example: Debt to Equity is a Ratio
and Return on Asset is a Return calculator.
Let’s see some Returns first
RETURN ON EQUITY:
Return on Equity is one of the most tracked
returns of a Company by investors. It measures profitability of Company in
relation to its shareholders money. It is calculated by dividing Shareholders
Equity from Net profit. There is no fixed standard mark on how much return on
Equity a company should have. Although, higher the better, at least from its
peers.
Return on Equity = Net
Profit/ Shareholders Fund
Where, Net Profit is profit available
to be distributed among shareholders or reinvestment in the business after all
other expenses are met and taxes paid.
And Shareholders Fund is Net value
shareholders will be entitled to get in case of closure of company. i.e. (Total Assets
– Total Liabilities). In other words, it is also Capital infused + accumulated
profits of years; (Capital + Reserves.)
In BWW Ltd, Return on Equity = 148.5/395 = 0.376
It is a return so it is presented in
percentage – i.e. 37.6%
RETURN ON CAPITAL
EMPLOYED:
Return on Capital Employed is
calculated to find profitability of a Company in relation to entire capital
used, that also includes long term loans.
Here the profit used to calculate
profitability is EBIT that is Earnings before Interest and Tax.
Return on Capital
Employed = EBIT/ Capital Employed
Where, Capital Employed is Total
Asset – Current Liabilities (or Shareholders Fund + Long term Liabilities, both
would give the same figure)
In BWW Ltd, Return on Capital
Employed = 228/610 = 0.3737 or 37.37%
RETURN ON ASSET:
Return on asset is also a
profitability measure. This one is calculated with Net Profit and Total Asset.
Return on Asset shows how well a company’s asset is being utilised to generate
profit.
This formula is mostly used in
Financial Sector Companies (Banks, NBFC); you would have probably seen them on
the last of the Income Statement after EPS on Quarterly results.
Return on Assets = Net
Profit/ Total Assets
In BWW Ltd, Return on Asset = 148.5/700 = 0.2121 or 21.21 %
Return on Equity and Return on Asset,
both uses net profit as numerator, but in Return on Equity, we use Shareholders
equity (their part in asset) as denominator; while in Return on Asset, we use
total asset as denominators. So you will see Return on Equity would be higher most of the time than Return on Asset.
COST OF DEBT:
The interest paid on Debt is Tax free,
so while calculating Cost of debt, we need to adjust it accordingly. Here is
the calculation, assuming Tax Rate to be 25%
Cost of Debt = Interest Paid / Total
Debt * (1Tax Rate); where total debt include short term and long term.
In BWW Ltd, Cost of Debt = 30/280 *(0.75) = 0.08 or 8%
Now, let’s see some Financial Ratios.
‘Going Concern’ is one of the trait of a Company; which assumes that the Company will keep paying its
obligations whenever they are due. When a Company has too much debt and it
starts making loss in business, its going concern comes at threat.
The most recent threat on going
concern was raised by VodaIdea Limited auditors. (June’21)
Solvency ratio is a way to ascertain
whether the Company will keep paying its obligations comfortably or not.
Below First 3 are solvency ratios:
DEBT TO EQUITY RATIO:
Debt to Equity Ratio is the most used
‘solvency ratio’ in Financial Analysis.
Debt to Equity Ratio determines
capability of a Company to repay its Debt. This Debt should include ShortTerm
as well as Long Term. Some of the websites uses only Long Term Debt for the
calculation.
Debt to Equity = Total
Debt/ Shareholders Fund
In BWW Ltd = (215+65) / 395 = 280/395
= 0.71
The Ideal Debt to Equity Ratio is 1.
Here it is 0.71; so it is good.
Debt to Equity Ratio higher than 1
makes a Company vulnerable if growth stops.
INTEREST COVERAGE
RATIO:
Company has to pay Interest on the Outstanding
Debt every year, whether it makes profit or not. So the Company should make
enough profit to cover interest part and also for dividend (though optional)
and business expansion.
Banks always check a company’s interest coverage before giving additional loan to the Company. Interest Coverage Ratio above 3 is preferred by Banks.
Here we take 2 Profit and Loss
Statement figures to calculate Interest Coverage Ratio
= EBIT / Total Interest
In BWW Ltd above = 228/30 = 7.6 times
This shows Company has generated
enough EBIT to pay its Interest for 7.6 times.
Some of the websites uses EBIDTA for
calculating Interest Coverage Ratio, which would be a liberal calculation. The
rational to do so, according to them, is that Depreciation and Amortisation is
just noncash adjustment!
If we take EBITDA, the Ratio would be
= EBITDA / Interest = 8.77 times
In my opinion, we should take EBIT in
calculation, as Depreciation and Amortisation comes from asset and cash will be
required to buy new assets.
DEBT SERVICE RATIO:
Another most used Solvency ratio is ‘Debt
Service Ratio’.
The company also has to pay back principal along with Interest; i.e. EMI. In our BWW Ltd, we have a total of 65 Short Term Debt (i.e. which is required to be paid back within 12 Months) and 215 of Long Term Debt. Now let’s assume Company is paying 25 from it’s Long term loan this year. So total Debt Service would be Interest + All Short Term Loans + Part of Long Term Loans
= EBIT/ Debt Service
= 228/120 = 1.9
A Debt Service Coverage Ratio above 2
is considered good.
Next 2 are ‘Liquidity Ratio’
CURRENT RATIO
Current Assets are the Assets which generally realises within 1 year; for a manufacturing company, factory is a Fixed Asset, but for a construction and real estate company, factory and buildings are inventory for selling, hence Current Assets. Current Assets can be Cash, Bank Deposits, pending customer dues, prepaid expenses like insurance etc.
Current Liabilities, similarly, are
liabilities, which are supposed to be paid within 1 year. These can be
outstanding expenses, Loan EMIs, Suppliers etc.
= Current Ratios = Current Assets /
Current Liabilities
= 235/90 = 2.6 times
We have enough liquidity to pay
current liabilities 2.6 times with our current assets.
Current Ratio above 2 is
considered good
QUICK RATIO:
It is also called Acid Test Ratio.
Here we take total current liabilities as denominator, but we deduct inventory
from current asset from numerator. Will the Company be able to pay its current
liabilities even if its inventory not sold? That’s why it is called acid
test.
Quick assets = Current asset – inventory (Some of the websites also deduct prepaid expenses as it is not supposed to come back)
= Quick Ratio = Quick Assets /Current
Liabilities
= (235120) / 90 = 1.27
We have enough liquid quick assets to
pay current liabilities 1.27 times.
Quick Ratio above 1 is considered
good
But for investors; the most important
return is ‘Return on Investment’; this has nothing to do with Company’s
Financial Figures. For different investors and traders, same company’s Return
on Investment can be different.
But that for some other day!
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