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 Pro-forma 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:

It tallied because its self-made excel sheet J

PROFIT AND LOSS STATEMENT:

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 * (1-Tax 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 Short-Term 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 non-cash 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

= (235-120) / 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!