Saturday, November 11, 2006

Financial ratios (Cont'd)

Mere statistics/data presented in the different financial statements do not reveal the true picture of a financial position of a firm. Properly analyzed and interpreted financial statements can provide valuable insights into a firm’s performance. To extract the information from the financial statements, a number of tools are used to analyse such statements. I looked at four important ratios in my last post. Here I try to understand another four, thanks to CRISIL.

Profitability margins broadly indicate both a company’s competitive position in an industry and the industry’s characteristics in terms of the strength of competition, pricing flexibility, demand supply scenario and regulation. A company’s profit performance offers a litmus test of its fundamental health and competitiveposition. Profitability margins, observed over a period of time, also indicate whether a company can sustain its current cash accruals. A profitable company exhibits ability to generate internal equity capital, attract external capital, andwithstand business adversity. PAT margin = Profit after tax / Operating income

Return on capital employed (RoCE) indicates the returns generated by a company on the total capital employed in the business. The ratio comprehensively indicates how well the company is run by its managers, and how unaffected it is by the extent of its leveraging or the nature of its industry. Aconsistently low RoCE reflects the company’s poor viability over the long term. CRISIL uses a three-year moving average RoCE in order to iron out the impact of short-term deviations and evaluate trends. RoCE is computed as:RoCE = Profit before Interest & Tax (PBIT) divided by (Total Debt + Tangible Networth + Deferred tax liability)

Net cash accruals to total debt (NCA/TD)is a ratio which indicates the level of cash accruals from the company’s operations in relation to its total outstanding debt. In other words, the ratio is a reflection of the number of years a company will take to repay all its debt obligations at current cash generation levels. The ratio is computed as follows:NCA/TD = PAT - Dividend + Depreciation divided by [Total debt (short and long term including off-balance sheet debt)]

The current ratio indicates a company’s overall liquidity position. It is widely used by banks in making decisions regarding working capital credit. The current ratio broadly indicates the matching profiles of short and long-term assets and liabilities. A healthy current ratio indicates that all long-term assets and a portion of the short-term assets are funded using long-term liabilities, ensuring adequate liquidity for the company’s normal operations.

As mentioned in the last post, although the eight parameters are crucial in analysing a company’s credit quality, they do not by themselves capture the company’s financial health in its entirety. Keep on chugging!!
Post a Comment