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We all have already learned how to analyse the Financial Statements, Balance Sheets and Cash Flow Statements.
But how can we know if a company is better than its peers or not.
Is it really possible to know if a company is better or worse than its peers?
The Answer is yes.
For that we need to conduct Financial Ratio Analysis, which is arrived at by inferring data from the Financial Statements which would give us a meaningful conclusion about the company. The data from the financial statements are converted into financial metrics that would assist in the decision-making process. Consider these like a Key Performance Indicators or an indicative number on which any company’s performance is measured. It also helps us to evaluate different companies or even specific areas within a company on a common measure which is comparable.
So, let’s get started on how to analyse some of these Financial Ratios.
To begin with, Financial Ratios can be majorly classified into 4 categories:
First is the Return Ratios: These are the ratios which represent the return that the company generates or has the ability to generate return for its shareholders. It basically shows whether a company is utilizing its Equity and Debt capital efficiently in order to be profitable and generate returns for its shareholders. Some of the Return Ratios include: Return on Equity (ROE), Return on Capital Employed (ROCE) and Return on Assets (ROA).
Second is the Efficiency Ratios: The Efficiency ratio basically shows us how the company is utilizing its assets and liabilities internally. It measures the ability of a company to use its assets and generate Income. It checks a variety of measures of a company such as the time it takes to churn cash from its debtors or the time it takes to convert inventory into cash. This makes the ratio an important one as an improved efficiency ratio which ultimately translates into better operational efficiency and gross profits. Examples are Asset Turnover Ratio, Working Capital cycle, Days of Receivables etc.
Third is the Solvency Ratios: The Solvency ratio is an important tool to measure a company’s financial ability and strength. It basically shows whether the company has enough assets to pay off the borrowings or debt which it has taken from external sources. Examples are Debt/Equity ratio, Interest Coverage ratio etc.
Fourth is the Valuation Ratios: Valuation ratios are one of the most important ratios used in Fundamental Analysis. It enables us to get an idea of how the market is valuing the company with respect to its peers. Valuation ratio is a pure comparative ratio as it can only be assessed when compared with its immediate peer or the broader sector per se. Few examples of Valuation ratios are: P/E ratio, EV/EBITDA ratio, Market Cap/Sales Ratio etc.
As we have known on a broader sense as to which ratios indicate what, now we can move forward as to how to analyse these numbers.
Financial Ratios alone just gives us a number as to what it has done in the past. Now to get a better picture of those numbers, we need to compare these ratios with similar ratios of different companies under the same sector. This is also known as Comparative Analysis or Relative Analysis of the companies.
Let’s take an example for the same with TCS and Tech Mahindra which operates in the IT services industry.
Suppose we want to check how efficiently TCS and Tech Mahindra deploys the capital it has in order to create returns for the shareholders. For that we need to check the Return On Equity i.e ROE and Return On Capital Employed ie. ROCE ratios.
TCS has a ROE of 36.18% and ROCE of 47.79%. Tech Mahindra has a ROE of 22.74% and ROCE of 24.98%.
From the ratios, it is clear that ROE and ROCE of TCS is higher than Tech Mahindra which basically states that TCS is able to generate better returns for its shareholders. ROE of 36.18% is indicating that TCS has the ability to generate better profits on its capital base.
It means that being an investor, TCS would generate better returns if I infuse my capital into the company.
Now let’s check, few of the Efficiency ratios which include: Working capital cycle, Asset Turnover Ratio and EBIT margin.
In case of TCS:
Working Capital Cycle is 40.64 days.
Asset turnover Ratio is 1.36
EBIT margins is 28.51%.
In case of Tech Mahindra:
Working Capital Cycle is 30.4 days.
Asset turnover Ratio is 1.11
EBIT margins is 16.5%.
From these ratios, we can analyse that Tech Mahindra has a better working capital cycle as it gets back its money in a lesser number of days as compared to TCS. In other words, clients pay Tech Mahindra in a better manner than TCS. Other than that, TCS has a better Asset Turnover and EBIT margin ratio which means it has better operations as compared to Tech Mahindra meaning that from an operations standpoint, TCS may be able to run the day to day operations more effectively.
Likewise, we have to look at the other ratios in order to get a clear picture of how a company operates as compared to its peers.
Financial ratios are basically used while doing a peer analysis so as to find out which company has a better ratio in the particular industry. The discussed ratios are just a few of the many. There are a lot more number of ratios out there.
But accessing all the ratios would be a hectic task and one would not be able to reach a conclusion just based on that.
So, it is important to know as to which and what ratio are actually needed to analyse which Sector.
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