8. Financial ratio analysis

[Music] in this video we'll try and understand the financial ratios of a company [Music] financial ratios are metrics that help you understand the financial health of a company financial ratios can be bucketed under three broad categories the profitability ratio the leverage ratio and the valuation ratios profitability ratios help you understand the profitability of a business profits are important as it helps expand the business and also pay dividends to its shareholders also you get a sense of how competitive the management really is some of the popular profitability ratios are operating margins patent margins and return on equity leverage in context of balance sheet refers to the debt the company has taken to run its operations leverage ratios are also called the solvency ratios and these ratios help us understand how well the business can sustain its day-to-day operations considering the debt they have on the books some of the popular leverage ratios are interest coverage ratio and the debt to equity ratio the third is the valuation ratios valuation ratio compares the stock price with the valuation of the company to get a sense of how cheap or expensive the company's stock really is popular valuation ratios are price to sales price to book and price to equity the first ratio that we will be looking at is the operating profit margin of a company the operating profit margin of a company by can be calculated by first calculating the ebitda of the company the ebit of a company is simply the difference between the total income and the expenses of a company once we calculate the ebitda we can calculate the operating profit margin by dividing ebitda by the revenue from operations this will yield us the operating profit margin of a company let's go ahead and calculate the operating profit margin of bajaj auto as a first step we first calculate the ebitda of bajaj auto like i mentioned earlier you can do this by taking the difference between the total income and the expenses now to calculate the ebitda margin i simply divide the ebitda number by the total income and as you can see the ebitda margin for bajaj auto is 21 let's move ahead and calculate the second profitability ratio of bajaj auto let's look at the pat margins to calculate the pad margin [Music] we divide the pad number which is also the bottom line of the company by the total income of the company by doing so we get a packet margin of 16 and a half percent for bajaj autumn the third profitability ratio that we will look at is the return on equity or simply the roe of a company the roe is also one of my personal favorites the return on equity or roe is a very important ratio as it helps the investor assess the return the shareholder earns for every unit of capital invested rov measures the company's ability to generate profits from the shareholders investment in other words roe shows the efficiency of a company in terms of generating profits to its shareholders let's move ahead to calculate the roe or the return on equity for bajaj auto to do that you simply have to divide the net profit or or the pat or the bottom line by the shareholders equity so i'm doing the math here [Music] and as you can see the ro for bajaj auto is 24 percent generally speaking higher the roe the better it is but while looking at the roe please do ensure that the company does not have debt on its books as the debt number can skew the roe numbers as well no i would also encourage you to visit the ratios chapter university to learn more about this if you have any queries around this please do post a comment on the chapter itself and i'll be happy to get back with a reply when you're analyzing a company from a profitability point of view ensure that the patent margin and the ebitda margins are trending upwards ensure that the margins are stable and also ensure that the return on equity is at least 25 we will now focus on the leverage ratio and the first ratio that we will look at is the interest coverage ratio the interest coverage ratio helps us understand how much the company is earning with respect to the interest burden it has the interest coverage ratio helps us interpret how easily a company can pay its interest payments for example if a company has an interest burden of rupees 100 versus an income of 400 then we clearly know that the company has sufficient funds to service its debt let's go ahead and calculate this for bajaj auto as you can see bajaj auto has a very small finance cost to it that's because bajaj auto does not have any long term or short term borrowings now let me change this and assume instead of three cross let's assume bajaj auto has an interest obligation of 450 cross so if this were the case then the then the interest coverage ratio for bajaj auto would be the ebitda number divided by the interest obligation or the finance cost of the company which i've assumed as 450 cross the interest coverage ratio tells us that company is earning 14 times more than its actual interest obligation hence this is a very good number when you're looking at the interest coverage ratio especially for companies which has debt on its book ensure that the number is on the higher side lower the number the riskier it is for the investor the next leverage ratio that will look at is the debt to equity ratio of a company the debt to equity ratio of a company is very straightforward you simply divide the debt of the company by the equity of the company a value of 1 on this ratio indicates an equal amount of debt and equity capital higher the debt to equity that is more than 1 indicates a higher leverage and hence one needs to be careful lower than 1 indicates a relatively bigger equity base with respect to the debt of the company let's calculate the debt to equity ratio for bajaj auto but as i just stated earlier bajaj auto does not have any debt on its book therefore it would be difficult to calculate the debt or equity ratio for bajaj auto but for the sake of this example let me assume a small debt number here and illustrate how to calculate the debt to equity ratio uh i'll assume that bajaj auto has a long term debt of 4000 crores and a short-term debt of 1500 crores and a total debt of 5500 crores now to calculate the debt to equity all i have to do is divide the total debt that is 5500 crores by the total equity of the company which is roughly about 21 000 crores and i get a debt to equity ratio of 0.25 as i as i mentioned earlier lower the number better it is and it indicates a larger equity base some of the other leverage ratios are debt to asset and the financial leverage ratio i would encourage you to visit varsity to read more about these ratios generally speaking when there is debt on the books of a company do pay particular attention to all the leverage ratios as it can reveal a lot of hidden stories we now focus our attention to the valuation ratios valuation ratios help us understand how cheap or expensive the stock is trading and we use this information to make an investment decision the first valuation ratio that we look at is the price to sales ratio of a company the price to sales ratio helps us compare the stock price of the company with the company's sales per share the formula to calculate the price to sales ratio is the current share price of the company divided by sales per share which also means to say we first need to calculate the sales per share of a company before we can calculate the price to sales of a company let's go ahead and calculate the price to sales ratio of bajaj auto like i mentioned earlier the first step in calculating the price to sales ratio is to actually calculate the sales on a per share basis to do that i simply have to divide the total sales number by the total outstanding shares in the market let's go ahead and do that on excel the total sales numbers is coated in cross so i'll have to convert this into rupee crore and i divide this by the total number of shares outstanding in the market i get the sales per share as rupees 1007 for bajaj auto now i can use this number to calculate the price to sales ratio as of today bajaj auto is trading at a share price of 3780. therefore the price to sales would work out to the price divided by the sales per share so as you can see the price to sales is 3.75 what this number indicates is that for every one rupee of sales that bajaj auto does the stock price as of today is valued at 3.75 times the sales while there is no ideal price to sales number you need to compare the price to sales of bajaj auto along with its peers to get a sense of how cheap or expensive the stock is here's one last thing that you need to remember while calculating the price to sales ratio assume that there are two identical companies company a and company b selling the same product both companies generate a revenue of 1000 rupees each however company a retains a pat of rupees 250 while company b retains a path of 150. in this case company a has a profit margin of 25 percent versus company b which has a profit margin of 15 here company a's sales is more valuable than company b hence if company a is trading at a higher price to sales then probably the valuation is justified because it has a higher fat margin so whenever you feel that the price to sales of a company is on the higher side always do pay attention to the pad margin to see why the price to sales is on the higher side let's move ahead and understand the next valuation ratio that is the price to book value now before we dig deeper into this we need to understand what the book value of a firm is the book value of a firm is simply the amount of money left on the table after the company pays off all its obligations you ask yourself the question what is the minimum value the company receives upon liquidation the answer to this lies in the book value of the firm the book value of a firm can be calculated by dividing the total equity of the company by the total outstanding shares of the company let's do that for bajaj auto the total equity of bajaj auto which is the sum of share capital and reserves and surplus is 21 662 crores i divide this by the total number of shares outstanding in the market the resulting number is the book value of the firm in this case it happens to be about 750 rupees per share now we can use the book value to calculate the price to book ratio to do that all i have to do is divide the share price by the book value as you can see when i divide the share price that is 3780 by 750 that is the book value i get the price to book value of 5. a high ratio could indicate that the firm is overvalued relative to the company's equity or the book value a low ratio on the other hand could indicate that the company is undervalued relative to the equity or the book value the last ratio that we will look at is the price to earning ratio of a company perhaps the price to earning or the p e ratio is one of the most popular ratios used widely by all the investors and the analysts now the first step while calculating the price to earning is to calculate the earnings per share itself you can calculate the earning per share or simply the eps of a company by dividing the path or the profit after tax by the total outstanding shares of the company so let's go ahead and calculate the eps of bajaj auto to calculate the eps i have to take the profit for the year in this case it happens to be 5213 crores and divide that by the total outstanding shares in the market and as you can see the eps for bajaj auto is 180 rupees i can now use the eps number that i have calculated to calculate the price to earning now to do this i simply have to divide the share price which is 3780 by the eps to get the price to earning the price to earning of bajaj auto is 20 we simply say the price to earning is 20x this means to save for every unit of profit that bajaj auto generates the market participants are willing to pay 20 times more to acquire the share let me just continue this i'll go ahead and change the stock price of bajaj auto from 3780 to 5000 and let's see what happens to the price to earning ratio as you can see the price to earning from 20 shot up to 27.72 what this means to say is as the share price of a company increases while the earning per share is flat the price to earning tends to increase you can extend the concept of price to earning to the index itself the price to earning of an index gives you a sense of how cheap or expensive the overall market is trading at you can always visit the website of national stock exchange to get the price to earning of nifty 50 which is the broadly tracked index and also make an estimate of how cheap or expensive the market is trading at to conclude we looked at the profitability ratios under the profitability ratios we looked at the ebitda margin pat margin on return on equity we looked at leverage ratio although the bajaj auto didn't have any debt on the books we assumed a certain number here and calculated the interest coverage ratio we calculated the debt to equity ratio and finally we looked at the valuation ratio and we we calculated the price to sales price to book and the price to earning ratios now whenever you calculate the financial ratios of a company don't look at it in isolation always try and compare how these ratios are faring compared to the peers in the industry that will give you a sense of how the company is performing within its sector finally don't base your investment decisions solely based on these financial ratios you need to look at the company that you are investing in from a holistic way you need to factor in both the qualitative and the quantitative aspects and then arrive at a decision to buy or sell the company in the next video we'll go ahead and understand the different techniques that you can use to value a company key takeaways from this video are you

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Length: 16min 47sec (1007 seconds)

Published: Fri Dec 24 2021