One important form of stock analysis is Ratio Analysis as it involves looking at a company’s various financial ratios. And understand how they have changed over time to spot trends or trouble spots in a company’s operations.
Why financial ratio analysis
A financial ratio by itself doesn’t necessarily tell you a lot. What’s more important is a comparison of how a company’s financial ratios are changing from one quarter to the other. Also how they compare a company’s financial ratios with other companies within an industry. Ratios hold no meaning unless are benchmarked against historical data like past performance or another company. Financial ratio analysis is also used for the valuation of a company.
Financial ratios are classified as follows
- Liquidity ratios
- Asset Management ratios
- Leverage ratios
- Profitability ratios
Liquidity ratios asses a firm`s ability to meet it’s short- term obligations using short-term assets. The short-term obligations are recorded under current liabilities which are due within one financial year. Short-term assets are the current assets of the company.
1. Current Ratio
The current ratio is equal to the total current assets upon total current liabilities. It indicates the extent to which current liabilities are paid off through current assets.
Current Ratio = Current Assets/ Current Liabilities
2. Quick asset Ratio
A major challenge with the current ratio is its assumption: all current assets can be converted into cash or equivalent to meet short-term obligations. We know this assumption is highly untrue in a practical scenario. Firms carry current asses, such as inventory, receivables and prepaid expenses. These assets can not be converted in to cash quickly.
To resolve this, a quick ratio, also known as the acid test ratio, is equal to cash convertible current assets, divided by current liabilities. It indicates the extent to which current liabilities are paid off through liquid current assets. For eg. marketable securities, cash, and accounts receivables.
Quick asset Ratio = (Current Assets – Inventory)/ Current Liabilities
3. Cash Ratio
The cash ratio examines the ability of the firm to settle short-term liabilities with the help of only cash and cash equivalents – marketable securities. The cash ratio indicates the extent to which current liabilities are paid through highly liquid assets.
Cash Ratio = (Cash +Marketable Securities)/ Current Liabilities
Understanding the concepts with examples is highly important to retain the ratios and what they signify.
For our analysis, we have chosen one upstream company Indian Oil Corporation Ltd (IOCL) and one downstream company Bharat Petroleum Corporation Limited (BPCL). We have chosen these two companies based on their market capitalization as IOCL has 1.27T rs. of market cap versus 1.11T rs. of BPCL.
Recommendation from the Lender’s Perspective
In accounting, liquidity is the ability of a company to meet its financial obligations as they are due. Use the liquidity ratio to measure a company’s ability to pay off its short-term debts.
The ideal current ratio for the oil and gas sector is around 0.97-1. The current ratio for IOCL has marginally increased from 0.76 to 0.81 last year.
The borrowings for BPCL in 2019 were very low that is why the current ratio was as 0.99x in 2019.
Conclusion: BPCL is better
The quick asset is computed by adjusting current assets to eliminate those assets which are not in cash majorly inventory. Generally, 1:1 is treated as an ideal ratio.
The quick ratio of BPCL (0.53) is more than that of IOCL (0.35).
Conclusion: BPCL is better
Asset Management Ratios
Asset management ratios also called efficiency ratios to indicate the efficiency of the use of assets in generating sales. There are five most important efficiency ratios. These are fixed assets turnover average collection period, inventory turnover, cash conversion cycle, and total assets turnover.
1. Average Collection Period
The average collection period is no. of days sales outstanding. It indicates the average time the firm must wait after making a credit sale before it collects cash. It shows the average number of days accounts receivables remain outstanding calculated as follows:
Average Collection Period = Receivables/ (Annual credit Sales/365)
A higher ACP indicates a liberal policy in which the firm gives more time to debtors for making payments.
2. Inventory / Stock Turnover
Inventory turnover indicates if inventory levels are reasonable concerning the cost of goods sold. It is calculated as follows:
Inventory / Stock Turnover = Cost of Goods Sold/ Average Inventory
Lower inventory turnover ratio relative to the industry standard indicates excessive, obsolete, or slow-moving inventory. While higher turnover indicates inadequate or non-relevant inventory or inventory shortage.
3. Cash Conversion Cycle
The cash conversion cycle shows an average number of days the cash is tied up in inventory and account receivables. The firm buys inventory, and cash is tied up in inventory for several days before they are sold and converted into receivables. Firms are also obtaining inventory on a credit basis, where the firm doesn’t tie up its funds in building inventory. Hence, the total number of days cash is tied up in inventory and receivables can be determined as follows.
Cash Conversion Cycle = Inventory processing Days + Average Collection Period – Payables Payment Period
4. Fixed asset Turnover
The fixed asset turnover ratio is the efficiency of the use of fixed assets for generating sales. It’s computed as sales by average net fixed assets, where average net fixed assets are equal to the average of beginning and ending BS values of net fixed assets. Net fixed assets are equal to gross fixed assets less accumulated depreciation.
Fixed Asset Turnover = Sales/ Average Net Fixed Assets
A lower asset turnover concerning the industry may indicate that the firm carries excessive fixed assets than are required. A higher turnover may indicate inadequate or outdated or depreciated fixed assets.
5. Total Asset Turnover
The total asset turnover ratio is the efficiency of the use of total assets in generating sales. Total assets are the sum of current and fixed assets. Total asset turnover is calculated as sales upon average total assets. The average total assets are average of total assets at the beginning and end of the period.
Total Asset Turnover = Sales/ Average Total Assets
Leverage ratios, also known as debt management ratios, measure two key aspects of the use of debt financing by the firm. As an analyst, we take interest in the level of financial leverage of the business and the ability of the firm to service its debt. The debt ratio, debt-equity ratio, and interest cover are as follows.
1. Debt Ratio
The debt ratio indicates the proportion of assets financed by both short-term and long- term debt. Compute this ratio as total debt, the sum of both short-term and long-term debt, as a percentage of total assets. A higher ratio indicates higher leverage.
Debt Ratio = Total Debt/ Total Assets
2. Debt – Equity Ratio
Use debt to equity ratio (D/E) as a measure of financial leverage. It focuses on long-term financing, both debt, equity. It is required when we want to examine long-term leverage. Total equity includes preferred equity and common equity. A higher debt-equity ratio indicates a potentially higher financial risk and greater leverage.
Debt – Equity Ratio = Long Term Debt/ Total Equity
3. Interest Coverage
The interest converges ratio measures the ability of a firm`s current operating earnings (EBIT) to meet its interest obligations. It is the ratio of EBIT to interest charged over the loans. The ratio shows the number of times the interest payment can be covered by the firm`s operating earnings. The larger the coverage better their ability to service interest obligations on debt.
Interest Coverage = EBIT/ Interest Charge
The profitability ratios, also called performance ratios, assess the firm`s ability to earn profits on assets, sales, and equity. These are important to determine and analyze the attractiveness of investing in company shares. We will examine five important profitability ratios as below:
1. Gross Profit Margin
The gross profit margin depicts the firm`s profit margin after deducting costs of goods sold (COGS) but before deducting operating expenses, interest and taxes. This ratio is also called the gross profit ratio.
Gross Profit Margin = (Sales – Cost of Goods Sold)/ Sales
GPM depends on the firm`s product pricing and cost control. The price of product impacts sales. Production costs such as labor, material, and overhead or the cost of purchases affect the COGS. A firm with a better ability to price products in line with inflation and the ability to reduce production costs or suppliers will be able to increase gross margins.
2. Operating Profit Margin
The operating profit margin depicts the firm`s profit margin after deducting the cost of goods sold and operating expenses but before interest and taxes. The operating profit is earnings before interest and taxes or EBIT as a percent of sales.
Operating Profit margin = EBIT/ Sales
3. Net Profit Margin
The net profit margin depicts the firm`s profit margin after deducting all the costs and expenses. It is a profit available for distribution to shareholders as a percentage of sales.
Net Profit margin = Net Income/ Sales
The lower operating profit margin is one reason for the lower net profit margin. It is possible that, since the firm is more debt-financed than an average firm, it has more interest expenses.
4. Return On Assets
The return on assets (ROA) depicts return earned on total assets employed. We finance total assets through both debt and equity. We must use return measure for this calculation as it reflects income to shareholders and debt holders. It is an important ratio from a financial analysis point of view.
We describe the return as net income available for distribution to shareholders plus the interest paid to debt holders. Divide return with the average assets. It represents the simple average of the total assets at the beginning, ending balance sheets.
Return on assets = (Net Income + Interest Expenses)/ Average total assets
5. Return on Equity
The return on equity measures the return earned on the capital provided by the stockholders. It is the net income as a percent of the average equity. Here the average common equity is a simple average of the common equity at the beginning, ending balance sheets. The net income is the income available for distribution to ordinary shareholders less preferred dividends.
ROE = Net Income/ Average Common Equity
Let’s understand what we learned using the same example of the petroleum industry.
Recommendation from Management Perspective
Total Asset turnover ratio
Total Asset turnover ratio measures the value of a company’s sales or revenues.
The asset turnover ratio has more or less remained stable around 1.6 for IOCL. They have not been able to deploy the assets more efficiently as compared to sales.
The financial analysis of the asset turnover ratio for BPCL shows that it has been stable at around 2.6.
Inventory Turnover ratio
The inventory turnover ratio is an efficiency ratio that shows a firm’s efficiency concerning its processing and inventory management.
It is stable for IOCL at around 6. The inventory turnover ratio for BPCL has remained stable at around 11. So, BPCL is more efficient in using its inventory.
Debtors Turnover ratio
A measure of accounts receivables turnover is the Debtors turnover ratio. It shows how quickly a company can collect its receivables. The debtor’s turnover ratio for IOCL is close to 45 for IOCL and 50 for BPCL.
Conclusion: BPCL is better
Overall Conclusion from a management perspective. It tells that BPCL is more efficient than IOCL in deploying its assets and managing its inventory and receivables.
Recommendation for financial ratio analysis from the Investor Perspective
Return on assets (ROA)
A company buys assets (factories, equipment, etc.) to conduct its business. Financial analysis of the ROA ratio tells you how good the company is at using its assets to make money.
The Return on assets employed has increased significantly for IOCL from 12.44% (2016) to 27.65% (2018). It means that the company is employing the assets in a better way.
For BPCL, the Return on assets employed has decreased from 30.88% to 12.49% in the past 5 years. While downstream companies, they own assets for oil refineries and storage facilities. For the upstream, companies generally hire contractors to buy drilling and exploration equipment.
Conclusion: IOCL is better
Return on net worth (ROE)
Equity is another word for ownership or net worth. Analysis of financial ratios like ROE tells you how good a company is at rewarding its shareholders for their investment. This is one of the most important ratios from the investor’s point of view.
For IOCL, the return on equity trend has been around 20%. But for BPCL, the ratios are substantially higher and for the 5 years, it has been around 25%.
Conclusion: BPCL is better
Return on capital employed (ROCE)
ROCE is the ratio of net income before interest and taxes to capital employed. It includes net worth, short term, and long term loans. For the year 2019, ROCE of BPCL is 14% which is above 11.86% of IOCL.
Conclusion: BPCL is better
The EBIDTA margin for IOCL has improved from 4% to 7% in the past 5 years. This was due to lower raw material costs and higher crude oil prices.
However, due to the same reasons, the refinery margin went down for BPCL. It was around 4-5% during the five years.
Conclusion: IOCL is better.
Net Profit Margin (PAT Margin):
PAT margins have been very low for IOCL and were 3.18% in 2019. However, for BPCL, it has been lower than that at 2.38%.
Conclusion: IOCL is better
Overall financial ratio analysis from Investor’s perspective
From the profitability point of view and return on equity and return on assets point of view, IOCL is a better choice than BPCL.
I hope now we have a clearer picture of how to do financial ratio analysis. Also, which ratios are the best understand the perspectives of stakeholders, management and lender along with the detailed examples.
Have a happy learning.