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Financial Literacy > Financial Ratios > Flashcards

Financial Ratios Flashcards

1
Q

How Financial Ratios can be classified?

A

1) Profitability ratios
2) Liquidity Ratios
3) Management Efficiency Ratios
4) Leverage ratios
5) Valuation Ratios

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2
Q

What Is Profitability Ratios?

A

It is used to evaluate the company’s ability to generate income as compared to its expenses and others cost associated with generation of income during a particular period

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3
Q

What does profitability ratio convey?

A

It conveys how well the company is able to perform in terms of generating profits

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4
Q

What are the commonly used Profitability Ratios?

A

1) Gross Profit Margin
2) EBITDA Margin(Operating margin)
3) PAT margin
4) Return on equity(ROE)
5) Return on capital Employed (ROCE)
6) Return on Asset(ROA)

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5
Q

What is Gross profit margin?

A

Gross Profit margin= Gross profit/(net sales)

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6
Q

What is Gross Profit?

A

Gross Profit= Net sales - Costs of goods Sold

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7
Q

What does the financial ratio “Gross profit margin” tells about?

A

1) Tells about the company’s profitability (in percentage terms) at the gross levels

2) Tells about the efficiency of the company in using its raw materials , labour and manufacturing related fixed assets to generate profit

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8
Q

How to calculate cost of goods sold?

A

Cost of Goods Sold= Cost of materials consumed +Purchase of stock in trade+cost of labour+cost of fuel and power+ cost of spares used+Any other significant cost

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9
Q

What is Net sales?

A

Net sales is net revenues

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10
Q

How Gross Profit Margin should be Analysed?

A

1) Gross Profit margin of the company in particular year should be compared with same in previous years ( see whether it’s declining or increasing(
2) Compare the Gross profit margin of the company with other competitors operating in same sector

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11
Q

What is EBITDA margin?

A

it is measurement of company’s earnings,before interests, taxes, depreciation and amortisation as a percentage of its net sales

EBITDA margin= EBITDA / Net sales

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12
Q

What Financial Ratio “EBITDA margin” tell us?

A

1) It tells us about the company’s profitability (in percentage terms) at the operating level. Hence known as operating margin
2) It tells about the efficiency of the management and operational efficiency of the company

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13
Q

How EBITDA Margin can be useful?

A

It is useful for comparing different companies from the same sector having different capital, Investment , Debt and Tax profiles

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14
Q

What is Profit after tax margin(PAT margin)?

A

PAT margin= PAT/Net sales

It is calculated after taking into account all other expenses including interest cost, depreciation and tax expenses .

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15
Q

How do you compare EBITDA margin along with PAT margin?

A

In case of many companies you will see that EBITDA margin is good enough ranging around 15-25% but their PAT margin is very low around 5-6% only. This may be because of high interest cost burden or huge depreciation expense due to working in an asset intensive business

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16
Q

What is Return on equity?

A

It measures how much profit a company generates with the money shareholders have invested.

Return on equity(ROE) = [Net profit/Average shareholders Equity]*100

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17
Q

What it means of ROE is higher?

A

Higher the ROE, the better it is for share holders. It tells the shareholders how effectively their money is being used.
However, you shouldn’t trust high ROE blindly. One of the biggest weakness of ROE is that it completely ignores debt. Hence for companies having high debt, ROE will give you a higher value

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18
Q

What is the average ROE of top Indian companies?

A

It is around 14-18% . A long term investor should prefer investing in company which has higher ROE . Author prefers companies having ROE over 18

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19
Q

What is the Return on Capital employed(ROCE)?

A

It measures how much profit a company generates with its total capital employed . Here the total capital includes both the equity and debt.(both long term and short term). Hence ROCE overcomes a major weakness of ROE ( it takes debt into consideration)

ROCE= [[Profit before INTEREST and Taxes /Total Capital Employed] *100

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20
Q

How total capital employed is calculated?

A

Total capital employed =shareholders equity+ Short Term Debt+ Long term Debt

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21
Q

How average share holders equity is calculated?

A

Average shareholder Equity= [ Beginning + Ending shareholders Equity] / 2

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22
Q

What is shareholders Equity?

A

Shareholders Equity= share capital + Reserves & surplus

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23
Q

What is Return on Asset(ROA)?

A

ROA measures how much profit a company generates using its total assets.

Return on Assets= [Net income+ interest rate *( 1- Tax rate ) ] / Total Average Assets

ROA reflects capital intensity of a company. The number will be different for different industries.

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24
Q

How much ROA to be considered Decent value?

A

5% considered as decent value

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25
Q

With what you have to compare a ROA of company with?

A

ROA of other companies in same industry

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26
Q

What are Liquidity ratios?

A

Liquidity measures how quickly assets are converted into cash . These ratios are used to evaluate the company’s ability to meet short term obligations without raising external capital

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27
Q

What does Liquidity ratio affects and indicates?

A

1) It affects the credibility and Credit rating of the company
2) It indicates financial stability of the company.

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28
Q

What are commonly used Liquidity Ratios?

A

1) Current ratio
2) Quick Ratio
3) Cash ratio

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29
Q

What is Current Ratios?

A

Current ratio= Current Assets / Current Liabilities

This shows the Liquidity position eg: how equipped is the company in meeting its short term obligations with short term assets

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30
Q

What does higher current ratio means?

A

Higher current ratio signals that the company’s day to day operations will not get affected by working capital issues.

higher current ratio generally means that a company has more current assets relative to its current liabilities, which indicates that it is better able to meet its short-term obligations or debts due within one year

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31
Q

How much lower current ratio should be concern?

A

Current ratio less than 1%

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32
Q

How current assets is calculated?

A

Current Assets = Cash & Equivalent + short term investments + Accounts Receivables + Inventories

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33
Q

In what case , investors may calculate the quick ratio?

A

When companies find it difficult to convert inventory into sales or receivables into cash . ( this may hit its ability to meet obligations)

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34
Q

What is quick ratio?

A

IIT measures company’s ability to meet its short term obligations with its most liquid assets

It is more conservative than the current ratio because it excludes inventory and other current assets , which can be more difficult to turn into cash

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35
Q

In what situations quick ratio is better indicator of liquidity than current ratio?

A

In situations where inventories are illiquid.

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36
Q

What is cash ratio?

A

cash ratio = (cash + cash equivalents)/ current liabilities

The cash ratio is a financial ratio that measures a company’s ability to pay off its current liabilities using only its cash and cash equivalents

It is even more conservative than the quick ratio

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37
Q

Is cash ratio is often used?

A

No cash ratio is rarely used as it is not advisable for any company to maintain high level of cash or cash equivalents to cover the current liabilities

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38
Q

How holding large amount of cash or cash equivalents on the balance sheet is considered?

A

Cash and Cash equivalents generate the lowest possible return hence holding a large amount of it on balance sheet is considered to be poor utilisation of assets .

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39
Q

How companies use excessive cash and cash equivalents?

A

Companies use it to either make acquisitions, pay off high interest bearing debt, buy back shares or pay additional dividend to shareholders.

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40
Q

What is management Efficiency Ratios?

A

It helps us to evaluate the ability of the management to use its assets and manage its liabilities effectively

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41
Q

What are the commonly used Management Efficiency Ratio?

A

1) Fixed Asset Turnover Ratio
2) Working Capital Turnover Ratio
3) Total Asset Turnover Ratio
4) Inventory Turnover Ratio
5) Inventory Number of days
6) Receivables Turnover Ratio
7) Day of sales outstanding

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42
Q

What is Fixed Asset Turnover ratio?

A

Fixed Asset turnover ratio= Net sales/ Average Net fixed assets

It is used to measure the operating performance of the company eg: how efficiently a company is producing sales with its machines and equipments

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43
Q

What does higher fixed asset turnover ratio means?

A

It indicates that a company has more effectively utilised investment in fixed assets to generate revenue

A higher fixed asset turnover ratio can also indicate that a company is able to generate sales without significantly increasing its investment in fixed assets. This can lead to higher profits and improved financial performance

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44
Q

What does declining higher fixed asset turnover ratio means?

A

A declining ratio needs to be analysed to understand if it is bad or good. It may be because of decline of sales or may be due to increase in fixed assets which may be because of expansion carried out by the company and its results are yet to be seen in company’s performance.

This could be due to a variety of reasons, such as outdated equipment or machinery, increased competition, or changes in the market environment

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45
Q

What is working capital Turnover ratio?

A

Working Capital Turnover Ratio= Net sales / Average working capital

Working capital turnover ratio is a financial ratio that measures a company’s ability to generate revenue using its working capita

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46
Q

How to calculate average working capital?

A

Average working capital= Beginning working capital+ Ending Working capital/ 2

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47
Q

What does high working capital turnover ratio means?

A

It indicates that management is being extremely efficient in using a company’s short term assets and liabilities to support sales .

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48
Q

What does low working capital turnover ratio indicates?

A

It indicates that business has too many accounts receivables and inventory assets to support it sales, which could eventually lead to an excessive amount of bad debts and obsolete inventory.

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49
Q

What is total asset turn over ratio?

A

Total Asset Turnover ratio= Net sales / Average total assets

This ratio is used to measure how efficiently a company can use its assets to generate sales

50
Q

How to calculate average total assets?

A

Average total assets= Beginning and ending total asset /2

51
Q

What is inventory turnover Ratio?

A

Inventory Turnover Ratio= Net sales / Average Inventory

This ratio helps us to analyse how popular are companies products

52
Q

What does high inventory turnover ratio means?

A

It means company’s products are really Popular .

53
Q

What does low inventory turnover ratio?

A

It means company’s products are not popular

54
Q

What is Inventory Number of days?

A

It tells about how much time(days) the company takes to convert its inventory into cash

Inventory Number of days= 365/ Inventory turnover ratio

55
Q

What does lower inventory number of days indicate?

A

1) Lower Number can indicate that company’s products are fast moving and popular which is a good sign but on other hand it can also indicate that the company has a limited production capacity which is not a good sign. This can be due to in inability to expand business due to shortage of funds or inability to raise fresh money, shortage of tea materials, etc.

You can come to know about such production capacity related issues only by reading the annual report of the company in details .

Hence as thumb rule , try to check production details whenever you see an impressive inventory number of days figure.

56
Q

What does Receivables Turnover ratio?

A

Accounts Receivable Turnover Ratio= Revenue/ Average Receivables

Indicates how many times in a given period of time , the company receives money from its debtors and customers. In other words , it shows a company’s effectiveness in extending credit and in collecting debts on that credit

Receivables turnover ratio is a financial ratio that measures how efficiently a company collects payments from its customers on credit sales

57
Q

What does higher Receivables Turnover ratio indicates?

A

Higher the value it is better , higher value indicates that company collects cash more frequently.

A high receivables turnover ratio indicates that a company is efficiently collecting payments from its customers and converting its accounts receivable into cash quickly

58
Q

What is day of sales outstanding?

A

It shows the average collection period of the company I.e : time lag between billing and collection
Days of sales outstanding = 365/Accounts Receivable Turnover Ratio

It represents the average number of days it takes for a company to collect payment from its customers after a sale is made on credit.

59
Q

What does Days sales outstanding indicates?

A

Both Receivable Turnover and Day sales Outstanding indicate the credit policy of the company.

60
Q

What does lesser days sales outstanding indicates?

A

Lesser the number of days better it is, as quicker the cash collected from the debtors, faster the cash can be used for other activities

low DSO indicates that a company is able to collect payment from its customers quickly, which can lead to improved cash flow and financial stability

61
Q

What does higher days of sales outstanding indicates?

A

A higher number indicates that customers are taking much longer time to pay their bills. This can be due to various reasons- company is offering long credit to customers to generate sales, products are sold to customers who are less credit worthy. , lot of competition in market or customers are dissatisfied with company’s products and services

62
Q

What if Days of sales outstanding is in increasing trend?

A

It means warning sign which needs to be thoroughly invested before investing in such company.

63
Q

Is best to analyse Days of sales outstanding on quarterly basis ?

A

Never

64
Q

What is Leverage ratio?

A

It measures the extent to which a company relies on debt financing in comparison to equity financing in its capital structure.

Leverage Ratios help us to understand the company’s financial leverage in a better manner

65
Q

Does companies prefer debt financing or Equity financing and why?

A

Companies prefer debt financing rather than equity financing. This is because of the cost of the debt is lower than the cost of equity mainly because of one important fact that interest payments on debt in tax deductible while dividend paid on the equity shareholders is taxable

66
Q

What are the commonly used leverage ratios?

A

1) Interest Coverage rAtio
2) Debt to equity ratio
3) Debt to Asset Ratio
4) Financial leverage ratio

67
Q

What is interest Coverage ratio?

A

It is also known as debt service ratio helps us to measure a company’s ability to meet its interest obligations on its outstanding debt

This ratio tells us how much company is earning relative to its interest burden. Hence we can determine how easily a company can pay interest on its outstanding debt.

Interest coverage ratio= EBIT/ Interest Expense

68
Q

What lower interest Coverage Ratio indicates?

A

It indicates an inability to service debts

69
Q

What higher interest Coverage Ratio indicates?

A

Higher it is better and higher ratio indicates a lack of debt on company’s balance sheet.

70
Q

When should prefer investing in companies when it comes to interest coverage ratio?

A

As a thumb rule , prefer investing in companies which has their interest coverage ratio much above 2.5

71
Q

What does it means when company’s interest coverage ratio falls below 1.5 ?

A

It means that company’s ability to meet its interest expenses may be questionable and any downturn in business in such condition can increase the possibility of default by company on interest payments. In severe conditions it can even lead the company to possible default or bankruptcy

72
Q

What does it indicate when interest coverage ratio is below 1?

A

It indicates that company is currently facing difficulties generating the cash necessary to pay its interest obligations

73
Q

For loss making company how will be interest coverage ratio?

A

It will be negative

74
Q

What is Debt to equity ratio?

A

This ratio compares company’s liability to its stockholder’s equity

It indicates how much debt company is using to finance its assets relative to the value of shareholder’s equity.

Debt to equity Ratio= Total debt/ Shareholder’s Equity

75
Q

Whether debt to equity ratio should be lower and higher? How much value it should be?

A

Lower the ratio better it is. In general Debt to equity ratio should not be above 2

76
Q

What does if company’s debt to equity ratio is higher than 2 means ?

A

It means company is getting more of their financing from borrowing which may pose a risk to it if debts levels are too high.
A greater degree to which operation are funded by borrowed money means a greater risk of bankruptcy if Buisness declines

77
Q

What if company’s debt equity ratio is very close to zero means?

A

It means company has no debt on its balance sheet.

78
Q

What need to be checked if company’s debt to equity ratio is close to zero ?

A

We need to check whether the company does not need any debt as of now to manage its operations or lenders are not willing to give money to the company.
This can be found out by examining
1) Capacity utilisation of the company
2) It’s working capital requirements
3) Operating cash flow
4) Credit rating of the company

79
Q

What is Debt to Asset ratio?

A

It compares a company’s total debt to its total assets.

This ratio tells us how much of the total assets of the company are financed through debt capital.

Debt to Asset ratio= Total debt/ Total Assets

80
Q

Whether the Debt to Asset Ratio should be lower or higher?

A

Lower the ratio better it is

81
Q

What does higher debt to asset ratio means ?

A

It means higher degree of leverage and greater the financial risk.

82
Q

What is Financial leverage ratio?

A

It tells us how much of the total assets of the company are financed through equity capital.

83
Q

Whether the financial leverage ratio should be lower or higher?

A

Lower the ratio better

84
Q

What does higher Financial leverage ratio indicates?

A

It indicates higher degree of leverage and consequently, greater the financial risk and hence investors need to be more careful.

85
Q

What is valuation ratios?

A

It determines the financial worth of the company ,it tells us whether the shares of company are over valued or undervalued.

Sometimes a decent Business at a very cheap valuation may be great investment option as against an exciting Business with an extremely high valuation.

86
Q

What are the commonly used Valuation Ratios?

A

1) Price to Earning(P/E) Ratio
2) Price to Book Value ( P/BV) Ratio
3) Price to sales Ratio
4) Price to Growth Ratio
5) Enterprise Multiple ( EV : EBITDA) Ratio
6) Dividend yield

87
Q

What is Price to Earning Ratio(P/E)?

A

Price to earnings ratio= price of the share / Earning per share

it measures the willingness of market participants to pay for stocks, for every rupee company generates

It is a reflection of market’s opinion of earning capacity and future business prospects of a company

88
Q

Which companies have high P/E ratio?

A

Companies which have high investor confidence and have higher market standing

Blue chip and some high growth companies have
P/E ratio that are high as 20 to 60 .

89
Q

What is the P/E ratio range for most small cap and mid cap companies?

A

It ranges between 5 to 20

90
Q

How is the P/E ratio of companies with high current earnings but dim future prospects?

A

Low P/E ratio

91
Q

As investor what should be your concern regarding P/E ratio?

A

Your primary concern should be future prospects of company not current performance

92
Q

How is the P/E ratio of company with low current earnings but bright future prospects?

A

High P/E ratio

93
Q

Is it wise to buy companies with too high valuation(P/E ratio =50 , authors choice ) ?

A

Never keeping very few exception.

Exception based on what?

94
Q

How to judge the P/E ratio in conjunction with prospects of future earnings and growth of the company ?

A

This can be done using P/E ratio in conjunction with PEG ratio.

95
Q

What is the Price to Book value ( P/BV ) ratio?

A

price to book value ratio = Price of the share/ Book value per share

96
Q

What does lower P/ BV ratio mean?

A

It means stock is undervalued.

It also indicate that investor sentiments and confidence towards the company is negative

97
Q

What does higher P/BV ratio means ?

A

It means stock might be overvalued

98
Q

How is the P/BV ratio of most companies?

A

Most companies have P/BV ratio greater than 1

99
Q

What companies value investors often consider expensive regarding to the P/BV ratio?

A

Companies with P/BV ratio of over 7or 8 Is considered expensive.

100
Q

What companies with values of P/BV ratio does value investor always search for?

A

Always in search of companies trading at P/BV ratio of below 1

101
Q

What is price to sales (P/S ratio)ratio?

A

P/S ratio= Price of the share / sales per share

Sales per share = Total sales / Total number of shares

It can be also calculated by dividing the company’s market capitalisation by total sales over the past 12 Months.

102
Q

What Does lower Price to sales (P/s ratio) means?

A

Investment is attractive

103
Q

When is Price to sales(P/S )ratio is more useful ?

A

Price to sales ratio is more useful in case of companies which are cyclical in nature , especially those who are experiencing cyclical low in their earnings or are currently unprofitable due to some reason. In such case P/E ratio does not give a clear picture or it gives negative P/E ratio which has no meaning

104
Q

What is Price Earnings to Growth (PEG)Ratio?

A

PEG ratio= (P/E ratio)/ Annualised EPS growth

Annualised EPS growth =
( EPS current year/EPS previous year)-1

PEG ratio gives better picture about valuation of company as compared to P/E ratio since it takes into consideration the company’s earning growth.

It tells us whether the stock is overvalued or underpriced

105
Q

When does PEG ratio is very useful and comes handy?

A

In cases where companies are having high growth rates their P/E ratio might be high , May be well above 30 or 40 and in such cases using just the P/E ratio would these high growth valuationcompanies appear overvalued relative to other and in such cases it is better to use PEG ratio to get the clear picture about company’s

106
Q

When is stock considered expensive in regard to PEG ratio?

A

When Peg ratio greater than 1 mean stock is relatively expensive .

107
Q

What it means When PEG ratio is lower than 1?

A

It means stock is below its Fair Value

108
Q

When PEG Ratio will be negative?

A

PEG ratio will be negative when there is De-growth in earnings as compared to previous period

109
Q

What does Enterprise Multiple(EV: EBITDA) Ratio means?

A

It is used to determine whether a company is undervalued or Overvalued

Enterprise Multiple (EV: EBITDA) Ratio= Enterprise value/ EBITDA

Enterprise value= Market Capitalisation+ Debt- cash

110
Q

What does Low Enterprise Multiple (EV:EBITDA) ratio means?

A

It means company might be undervalued

111
Q

What does High Enterprise Multiple (EV:EBITDA) ratio means?

A

It indicates that the company is overvalued

112
Q

What does the Typical Enterprise Multiple (EV:EBITDA) ratio value ranges?

A

Typically it ranges between 10 to 15

113
Q

What is Dividend Yield?

A

It is Financial Ratio that indicates how much a company pays out in dividends each year relative to its share price

Dividend Yield = Annual Dividend per share/ Price of the share *100

114
Q

What does very high current ratio indicates?

A

However, a very high current ratio may not always be desirable as it may indicate that a company is not using its current assets efficiently. For instance, if a company is holding excess inventory or has a large amount of cash that is not being utilized effectively, it may result in a higher current ratio

115
Q

How much should be quick ratio?

A

A quick ratio of 1 or higher is generally considered healthy, as it indicates that a company has enough current assets to cover its current liabilities without relying on the sale of inventory or other less liquid assets

116
Q

What does quick ratio below indicates?

A

quick ratio below 1 may indicate that a company may have difficulty paying its short-term debts without liquidating some of its inventory or other assets

117
Q

What is the Ideal Cash ratio value?

A

The ideal cash ratio varies by industry, but in general, a ratio of 1:1 or higher is considered to be a good indicator of a company’s short-term financial stability.

118
Q

What does very high total asset turnover ratio indicates?

A

A very high ratio could indicate that the company is not investing enough in its assets to support its revenue growth.

as it can also indicate that a company is operating with a low profit margin or has a high level of debt

119
Q

What does low total asset turnover ratio indicates?

A

low ratio could indicate that the company is not using its assets effectively and may need to improve its operations or invest in additional assets to drive growth

120
Q

What does high Total asset turn over ratio indicates?

A

high total asset turnover ratio generally indicates that a company is efficiently using its assets to generate revenue

121
Q

What does lower receivables turnover ratio indicates?

A

low receivables turnover ratio may indicate that a company is having difficulty collecting payments from its customers or has a high level of bad debts, which can negatively impact its cash flow and profitability.

Financial Literacy (5 decks)

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