Analysing Company with Financial Ratios

Profitability

Profitability is "the ability for a company to earn satisfactory profit so that the investors and shareholders will continue to provide capital to it." For this reason profitability ratios are much observed by the investors and by the shareholders.

One of the principal ratios related to profitability is profit margin. Two major profit margins widely known are: "net profit margin" (NPM) and "gross profit margin" (GPM). Both of these margins are calculated by dividing income (profit) by turnover (sales). In the Gross Profit Margin, income is calculated before operating expenses, interest and tax, whereas in the net profit margin all these expenses are taken out from income.

NPM is the function of the sale price of the product and efficiency of sale cost. For the companies, which are selling a unique product to a captive market may be able to charge a premium price and thus generate greater NPM. A company, which is selling a generic product in a highly competitive market, will have a low NPM. Therefore, it must be a very efficient company.

Another principal ratio is return of capital employed (ROCE). It is the amount of profit as a percentage of capital employed. This ratio is the most important measure of the business performance of a company, since it assess how much the capital invested has earned during a period. The fall of ROCE is not a good sign for an investor who is considering investment on this company.

Liquidity

Being a profitable company does not mean that it can pay its creditors, expenses, loans when they become due. Companies' ability to meet its requirements for both expected and unexpected cash demand is defined as liquidity. All businesses need some liquidity to operate. If company has too little liquidity, it may result in bankruptcy in case of urgent money demands. However, having more liquidity than what the business needs could take the profit away, since they are low returning investments.

There are two main ratios as liquidity indicators: "current ratio" and "quick ratio". Both ratios are defined as the ratio of current assets to current liabilities, whereas, in the quick ratio, stocks are excluded from the current assets. These ratios are observed by the suppliers and providers to assess the ability of the business to pay its dues.

Recommended values for current ratio is 2:1, meaning business should have twice the current assets of its current liabilities and for quick ratio is 1:1. However, the real values may be much different from those suggested values, since different businesses operate in different ways. Current ratio is expected to be a bit higher for smaller companies, since they may have to cover unforeseen cash demands from current assets. It is also possible to figure out how much stock is used by looking at the differences between current and quick ratios.

Gearing (Debt Management)

Gearing is a method of comparing how much of the long-term capital of a business is provided by equity (ordinary shares and reserves) and how much is provided by prior charge capital (preference shares and loans). When a company makes profit, first the fixed claims of preference shareholders and creditors are met. Then, rest of the profit is shared by ordinary shareholders. If this is a profitable company, ordinary shareholders become main beneficiaries, if it is not, then they may receive a little or nothing at all.

A business with larger prior charge capital to equity capital is said to be highly geared. High level of gear carries a risk and represents legal obligations to pay dividends periodically. Failure to make these payments can result in bankruptcy.

Debt ratio is used to measure the gearing level of the business and it is calculated as the prior charge capital divided by total assets.

Investor’s Ratios (Market Value)

These ratios reflect relationship between the amount of return and the value of investment provided by ordinary shareholders.

One principal ratio is earnings per share (EPS) and it measures the profit earned per share. It is calculated by ratio of profit (distributed or retained) to the number of ordinary shares. The higher EPS attract more investors and more equity to business.

In order to make more comprehensive analysis we might need additional investor’s ratios like dividend yield and price earning ratios. Dividend yield ratio would give information to shareholders how much dividend is earned from the market value of the shares. And price earning ratio is calculated by dividing the company's share price by EPS. This gives an indication of how many times an investor is paying for a company's share verse a company's earnings. Higher P/E ratios are often seemed as an indication for a company that is growing faster than average and investors believe that the company's earnings will be higher in the future.

Apart from the additional ratios, an analyst may request more than 2 years of ratios to see wider perspective of the company performance. However having many years of ratio values and different types of ratios do not tell about the size of the business, other financial statements must be investigated for full analysis.

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