Fundamental analysis uses revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth. In this article we will discuss all about the various financial terms used in the fundamental analysis of the company. We are going to simplify all these terms here.
Financial ratios can be classified into different categories, here we will simplify it in the following categories
Financial ratios can be classified into different categories, here we will simplify it in the following categories
- Profitability Ratios
- Leverage Ratios
- Valuation Ratios
- Operating Ratios
- EBITDA Margin (Operating Profit Margin)-The Earnings before Interest Tax Depreciation & Amortization (EBITDA) margin indicates the efficiency of the management. It tells us how efficient the company’s operating model is. EBITDA Margin tells us how profitable (in percentage terms) the company is at an operating level. It always makes sense to compare the company’s EBITDA margin versus its competitor to get a sense of the management’s efficiency in terms of managing their expense.
To calculate the EBITDA Margin, we first need to calculate the EBITDA itself.
EBITDA = [Operating Revenues – Operating Expense]
Operating Revenues = [Total Revenue – Other Income]
Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]
EBIDTA Margin = EBITDA / [Total Revenue – Other Income] - PAT Margin- While the EBITDA margin is calculated at the operating level, the Profit After Tax (PAT) margin is calculated at the final profitability level. At the operating level, we consider only the operating expenses; however, other expenses such as depreciation and finance costs are not considered. Along with these expenses, there are tax expenses as well. When we calculate the PAT margin, all expenses are deducted from the company’s Total Revenues to identify the company’s overall profitability.
PAT Margin = [PAT/Total Revenues] - Return on Equity (ROE)-The Return on Equity (RoE) is a critical ratio, as it helps the investor assess the return the shareholder earns for every unit of capital invested.RoE shows the efficiency of the company in terms of generating profits to its shareholders. Obviously, the higher the RoE, the better it is for the shareholders. In fact, this is one of the key ratios that help the investor identify investable attributes of the company. The average RoE of top Indian companies varies between 14 – 20% to give you a perspective. But, I personally prefer to invest in stock which have an RoE of 25% upwards.
This ratio is compared with the other companies in the same industry and is also observed over time.
Also note, if the RoE is high, a good amount of cash is being generated by the company. Hence the need for external funds is less. Thus a higher ROE indicates a higher level of management performance.
RoE can be calculated as: [Net Profit / Shareholders Equity* 100] - Return on Asset (ROA)- Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to use the assets to create profits. A well-managed entity limits investments in non-productive assets. Hence RoA indicates the management’s efficiency at deploying its assets. Needless to say, the higher the ROA, the better it is.
RoA = [Net income + interest*(1-tax rate)] / Total Average Assets - Return on Capital Employed (ROCE)-The Return on Capital employed indicates the company’s profitability, taking into consideration the overall capital it employs.
Overall capital includes both equity and debt (both long term and short term).
ROCE = [Profit before Interest & Taxes / Overall Capital Employed]
Overall Capital Employed = Short term Debt + Long term Debt + Equity.
Leverage ratios mainly deal with the overall extent of the company’s debt, and help us understand the company’s financial leverage better.
We will be looking into the following leverage ratios:
- Interest Coverage Ratio- The interest coverage ratio helps us understand how much the company is earning relative to the interest burden of the company. This ratio helps us interpret how easily a company can pay its interest payments. For example, if the company has an interest burden of Rs.10 versus an income of Rs.50, then we clearly know that the company has sufficient funds to service its debt. However a low interest coverage ratio could mean a higher debt burden and a greater possibility of bankruptcy or default. The formula to calculate the interest coverage ratio:
- [Earnings before Interest and Tax / Interest Payment].
- The ‘Earnings before Interest and Tax’ (EBIT) is: EBITDA - Depreciation & Amortization
- Debt to Equity Ratio - It measures the amount of the total debt capital with respect to the total equity capital. A value of 1 on this ratio indicates an equal amount of debt and equity capital. Higher debt to equity (more than 1) indicates higher leverage and hence one needs to be careful. Lower than 1 indicates a relatively bigger equity base with respect to the debt. The formula to calculate Debt to Equity ratio is:
- Total Debt/Total Equity. Please note, the total debt here includes both the short term debt and the long term debt.
- Debt to Asset Ratio- This ratio helps us understand the asset financing pattern of the company. It conveys to us how much of the total assets are financed through debt capital. The formula to calculate the same is:
- Total Debt / Total Assets
- Financial Leverage Ratio- The financial leverage ratio gives us an indication, to what extent the assets are supported by equity. The formula to calculate the Financial Leverage Ratio is:
- Average Total Asset / Average Total Equity.
The Valuation ratios compare the company’s stock price with either the profitability of the company or the company’s overall value to get a sense of how cheap, or expensive the stock is trading. The valuation ratio compares the margin of safety of owning the stock. Valuation ratios are usually computed as a ratio of the company’s share price to an aspect of its financial performance. We will be looking at the following three important valuation ratios:
- Price to Sales (P/S) Ratio - This ratio compares the stock price of the company with the company’s sales per share. The formula to calculate the P/S ratio is:
- Price to sales ratio = Current Share Price / Sales per Share
- Price to Book Value (P/BV) Ratio - The “Book Value” of a firm is simply the amount of money left on the table after the company pays off its obligations. Consider the book value as the salvage value of the company. The Book Value aka BV can be calculated as follows:
- BV = [Share Capital + Reserves (excluding revaluation reserves) / Total Number of shares].
After calculating the BV we can easily calculate by P/BV. It differ industry to industry like software companies book value is usually low so this ratio will be seen high while comparing to sugar industry it will close to 1 or 2.
- Price to Earnings (P/E) Ratio - The P/E of a stock is calculated by dividing the current stock price by the Earning Per Share (EPS), but P/E doesn't show the clear picture of the valuations so while looking at the P/E ratio, keep the following key points in your mind:
- P/E indicates how expensive or cheap the stock is trading at. Never buy stocks that are trading at high valuations.
- The earnings can be manipulated.
- Make sure the company is not changing its accounting policy too often.
- Always how the depreciation is treated. Provision for lesser depreciation can boost earnings. Provisions in case finance companies is very much important.
- Earnings must be on rise with the cash flow.
The Operating Ratios also called the ‘Activity Ratios’ measures the efficiency at which a business can convert its assets (both current and noncurrent) into revenues. This ratio helps us understand the efficiency of the management of the company's operations.
Some of the popular Operating Ratios are:
- Fixed Assets Turnover Ratio- It tells us how effectively the company uses its plant and equipment. Fixed assets include the property, plant and equipment. Higher the ratio, it means the company is effectively and efficiently managing its fixed assets.
- Fixed Assets Turnover = Operating Revenues / Total Average Asset
- Working Capital Turnover Ratio -Working capital refers to the capital required by the firm to run its day to day operations. The working capital turnover ratio is also referred to as Net sales to working capital. The working capital turnover indicates how much revenue the company generates for every unit of working capital. The formula to calculate the Working Capital Turnover:
- Working Capital Turnover = [Revenue / Average Working Capital]
- Total Assets Turnover Ratio - It indicates the company’s capability to generate revenues with the given amount of assets. Here the assets include both the fixed assets as well as current assets.
- Total Asset Turnover = Operating Revenue / Average Total Assets
- Inventory Turnover Ratio - Inventory refers to the finished goods that a company maintains in its store or showroom with an expectation of selling the finished goods to prospective clients. This means that the stored capacity of the finished goods is inventory. Inventory turnover means a company how many time sold his inventory in the year. Let say a company X sold 300 units of some goods in a year and his stored capacity is 50 units then total units sold in a year/stored capacity will be its inventory turnover ratio i.e. 300/50=6. If the product is really popular the inventory turnover would be high. This is exactly what the ‘Inventory Turnover Ratio’ indicates. The formula to calculate the ratio is:
- Inventory Turnover = [Cost of Goods Sold / Average Inventory]
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