As a part of our commitment to deliver an easy-to-understand series on various financial ratios for you, and buoyed by the appreciation received for the first part of this series – here is the second part of our coverage of popular financial ratios for fundamental analysis of stocks.
In the last part, we covered Earnings per Share, Price-to-Earnings, Book Value, Price-to-Book Ratio and Dividend Yield. In this part, we will discuss Earnings before interest, taxes, depreciation, and amortization (EBITDA), Profit after Tax, Return on Equity, Return on Capital Employed, Debt to equity ratio, Acid ratio, Working capital ratio, Price to sales ratio and Interest coverage ratio.
The earnings before interest, taxes, depreciation, and amortization (EBITDA) formula is one of the key indicators of a company's financial performance. It determines the earning potential of a company. Using EBITDA, profitability is calculated without allowing the impact of factors like debt financing, depreciation, and amortization (D&A) expenses.
There are two EBITDA formulas—the first formula uses operating income as the starting point, while the second formula uses net income.
EBITDA using Operating Income = Operating Income + Depreciation & Amortization
Operating income is a company's profit after subtracting operating expenses or the costs of running the daily business, i.e., sales minus operating expenses, such as wages and cost of goods sold (COGS).
EBITDA using Net Income = Net Income + Taxes + Interest Expense + Depreciation & Amortization
Unlike the first formula, which uses operating income, the second formula starts with net income and adds back taxes and interest expense to get to operating income.
Profit after tax can be termed as the net profit available for the shareholders after paying all the expenses and taxes by the business. After paying all the operating expenses, non-operating expenses, interest on loans etc., the business is left out with the profit before tax or PBT. Tax is calculated on this available profit, which is then deducted to calculate the PAT.
Profit After Tax (PAT) = Profit Before Tax (PBT) – Tax Rate
Return on equity is a measure of financial performance calculated by dividing the company’s net income by its shareholders' equity. Shareholders' equity being equal to a company’s assets minus its debt, ROE indicates the return on net assets. It indicates the company’s profitability and its efficiency in generating profits. ROEs vary with industry or sector and should be studied accordingly.
The formula for ROE is Net Income/Shareholder's Equity.
Return on capital employed is a financial ratio that can be used to assess a company's profitability and capital efficiency. ROCE shows how well a company is generating profits from the capital it is putting to use. ROCE considers debt as well as equity.
The formula for ROCE is,
Earnings Before Interest and Taxes/Capital Employed
(Capital Employed = Total Assets - Current Liabilities)
Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. D/E shows the degree to which the company is financing its operations through debts rather than its resources. The debt-to-equity ratio is a type of gearing ratio.
Among comparable companies, a higher D/E ratio suggests a higher risk for the company’s financials, while a particularly low one may indicate that a business is not taking any advantage of debt financing to expand.
Debt/Equity = Total Liabilities / Total Shareholder's Equity
ATR is also known as the quick ratio. It measures the liquidity of a company by calculating the extent to which current assets can cover current liabilities. The quick ratio uses only highly liquid current assets that can be converted to cash in less than 90 days. A good ATR assures the stakeholders that the company's balance sheet has enough liquid funds to meet its current liabilities.
The difference between ATR and the popular current ratio is that ATR excludes inventory, which can be hard to liquidate instantly.
In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills. A low ATR suggests that the company is cash-strapped. But businesses like retail may have low STR as they are often dependent on inventory.
The formula for the Quick Ratio is
(Cash & Cash Equivalents + Current Receivable + Short-Term Investments) / Current Liabilities
The acid-test ratio is affected by factors like how much time a company takes to collect its receivables, and how well they manage and provision bad debt allowances.
Working capital turnover is a ratio that measures the efficiency of a company in its use of working capital to support sales and growth. Also known as the net sales to working capital ratio, WCT measures the relationship between the funds used for company operations and the revenue generated by the company. A higher working capital turnover ratio indicates that a company is generating higher sales.
Net annual sales are gross sales minus returns, allowances, and discounts, while average working capital is average current assets less average current liabilities. If the management uses the company’s short-term assets and liabilities efficiently to support sales, the WCT will be high. WCT will be low if the business has high accounts receivable and inventory against its sales. Here low WCT would indicate the possibility of high bad debts or obsolete inventory.
The P/S ratio, also known as the sales multiplier or revenue multiplier, compares a company’s stock price to its revenues. It is calculated by dividing the company’s stock price by the sales per share. It can also be calculated by dividing the market cap of the company by the total sales of a specific period.
The ratio indicates the value of each rupee of revenue generated by the company, that is the value investors are willing to pay. A low P/S ratio means that the stock is undervalued, while an unusually high ratio means that the stock is overvalued.
The P/S ratio doesn’t take debt into consideration, but the enterprise value-to-sales ratio (EV/Sales) does.
The interest coverage ratio, or Times Interest Earned (TIE) ratio, is a debt and profitability ratio. It determines the ease with which a company can pay interest on its outstanding debt. ICR is calculated by dividing a company's EBIT by its interest expenses during a specific period.
This formula helps lenders, creditors and investors to assess the risk of lending or investing in a company.
If the ICR of a company is lower than 1.5, its capacity to meet interest expenses comes under doubt. However, looking at the ICR of a company for a specific period or day may not give you an unbiased picture. Instead, the ICRs of the company over a longer period and different timelines will give you better clarity of the company’s financial position.
An understanding of these ratios will help you in analysing the financial performance of various companies. A better understanding will also aid you in comparing different stocks and making informed investment decisions.